T2W Trading Community

It is commonly said that a powerful rule to determine if it is time to get out of a position is to ask your self: “If I were out of the position, would I like to enter the market?”. If the answer is “No” then the rule advises that the position must be liquidated. Don’t let the simplicity of the rule fool you. Seeing your position from a third-person position is the best way to take away the emotions from your trading. Since however you compute the RR ratio before entering a trade, you must also calculate it as long as your position is active to ensure that you continuously see your active position as if you were out of it and you were trying to evaluate if it merits entering the market.

Critical Observations
Before choosing whether it merits using the methods described above, you must consider the following facts:

Adequate Time.
Most intraday traders and scalpers make many small trades during a day. It is mentally laborious to continuously monitor and adjust two trailing stops, a CE level and a Profit/Loss ratio at the same time.

The ambiguity of Closing Price in intraday charts.
I mentioned above that it is better to base the CE levels in closing prices. The Closing Price in a chart has a meaning only if it represents the last trade in a time frame between periods where the market is actually closed. Thereupon, for the markets which are not continually traded, only the closing prices in daily and weekly charts have true meaning. The closing prices of monthly and yearly charts follow in order of importance since the evaluation of positions and portfolios at the end of months and years are usually used as milestones by investors. Last in order of importance (if any) lie the closing prices of intraday charts (5min, 15 min, 60 min. etc.).

The use of two stop loss levels is equivalent to having two positions simultaneously.
Indeed, the first position is the portion of the full position attached to the first stop loss level and the second position is the remaining portion of the full position which is attached to the second stop loss level. Many brokers charge a considerable minimum commission per order. Since intraday traders and scalpers make many small trades during a day It is not always a  good idea to split their position into two parts using two stop loss levels. On the other hand, due to the nature of trade selection for position traders (especially when fundamentals are used in addition to technicals), the good opportunities are not so many and grabbing all opportunities that arise is essential. The use of two stop loss orders helps in a better management of these opportunities.

Immediate from the above is that if you are going to use two trailing stop loss levels then use them in position trades  mostly (that is, trades that are expected to last from several days to several months). You should attempt to use them with caution in intraday trades only if you trade significant volume per trade, you are very experienced and rapid in making decisions.

The use of a CE level can be used for intraday trading or for markets that are open 24 hours a day but in this case don’t rely on closing prices of charts. As soon as the CE level you have set is penetrated, start thinking of an exit point.

The Reward/Risk ratio on the other hand is a different story. It must be continuously calculated and been taking into account in all type of trades you make. Say for example that you buy a stock at 30$ setting one stop loss order at 29$ based on a support level. If your expect that the price of the stock will reach 34$ and the minimum RR you demand is 3 then the set up is OK since you risk 1$ to gain 4$ (which means that RR = 4 in this case). Suppose that you buy the stock at 30$ and its price rise at 32$. You trail the stop at 30$. Does it make sense? The answer is no. You are now risking 2$ to gain 2$ which gives a current RR ratio of 1. The stop in this case must be higher than 32$ to produce a RR ratio 3 or higher.

Linking Reward/Risk to the Stop Selection
Having set a constant minimum desirable Reward/Risk ratio (namely minRR) for a trade helps in defining the maximum distance of a trailing stop from the current price. More precisely, the stop must not be more than   away from the current price at any time, where G$ is the expected gain from the trade. (Note that G changes as the price of the tradable changes. Also it is advised that minRR is close to 3).

Using elementary algebra it is easy to see that a barrier for stops is determined by the number 

, where P$ is the current price of the tradable, T$ is its target price (the price that will produce the expected gain) and minRR is the constant minimum accepted Reward/Risk ratio. More precisely, for a long position, the stop prices must be greater than  SB $ and for a short position, the stop prices must be lower than  SB $.

If you consider using two stop loss levels for a trade then  note that the SB barrier must be used for both stops and not the average stop loss. The reason for this is that the use of two stop loss levels is equivalent to having two lesser positions simultaneously.

Some Final Thoughts
I often hear that “You have not made or lost real money from a trade as long as this trade is not closed”. This  may seem true from the first place because as long as you are in a position you think that anything can happen. It is not true however since every claim, skill or thing in this world has a value at any given time and the same holds for all trading positions. Closing your trade will not give you the profit or loss. You already have it. If you bought a stock at 30$ and you can sell it now at 40$ then you have a 10$ profit regardless of whether you actually sell it now at 40$ or not. Think of this profit as a part of your capital. You now have 40$ put in this stock. This is the only way you will respect this 10$ you have earned. You owe it to your self to respect it. This 10$ was not given to you for free after all. It is your reward for taking the risk to buy the stock at 30$. Define your new stops and Reward/Risk ratio  now based on your 40$.

Epilogue
Some points of the present article may not be unfamiliar to you. At times, you may have closed a portion of a position and not the full position and at other times you may have decided that it is time to get out of a position but not immediately. The first key point of the article is to indicate that these concepts should be incorporated in a rigid method. The second key point of the article and probably the most important is that you should continually evaluate the stops and Reward/Risk ratios to determine if it worths being in a trade or not.

References

[1] Murphy, John J.  [1986], Technical Analysis of the Futures Markets,, New York, New York Institute of Finance..
[2] Schwager, D. Jack [1989]. Market Wizards, Interviews With Top Traders, New York Institute of Finance.