GENERIC STUFF TO LOOK AT WITH OPEN POSITIONS
How you look at the market during off-market hours will depend on your open positions. A person who is long and one who is short could both have positive outlooks on their position and may have different criteria and expectations they look for. People with different indicators or strategies will look at different things to help them decide what they want to do. The best I can do is give you some basic questions you should answer to guide you with drawing up scenarios.
Are the Conditions You Entered the Trade for Gone?
One of my main criteria for getting out of a trade is that the reason I got in no longer is in play. Say you were playing poker (Texas Hold em) and stayed in to see a flop because you had two clubs. You were looking for a flush, but then if no other clubs came out you should fold, assuming you didnt improve your hand with a good pair or three of a kind, or something like that. The reason you folded is because you didnt get what you were looking for. Beyond that, you are just hoping you get the cards you need to win and hope is never a good strategy. The same holds for trading. If Im long because of a breakout of a trend line and then that breakout fails, its time to get out. As you read this you may be wondering what this has to do with drawing up scenarios. When you are making your game plan and scenarios, you need to note at what point the conditions you entered for would no longer be there and what market scenario would get you to that point.
Whats the Worst-Case Scenario?
Though one can never really predict the worst-case scenario, you should be prepared in case it does happen. If the market has been ranging an average of 100 points a day for quite a while, you wouldnt expect that one day it will drop 400 or 500 points. But it does happen every now and then. It happened to me in late February of 2007 (Figure 9.14), when I put on an options position that got decimated in two days. You also occasionally get a day when the market is down 200-plus points at 2:30 P .M . only
to close positive by 150 points. Though we cant plan for these events, you should have worst-case protective stops in the market just in case. And every day that the market is down or up big, you should keep in mind that there is a small chance it could reverse big and have a backup plan in case it does. Its kind of like living every day like its your last; one day you will be right.
Now, lets forget about the extreme moves because they dont happen that often. But even thinking about normal moves, you should get yourself prepared for being dead wrong or the market turning on you. If you are long and making money, you should have a scenario for what you will do if the market decides to prove you wrong. For example, in the trade I showed earlier in this chapter my worst-case scenario is that I am wrong and the market drops, continuing its downtrend. I was willing to risk to the low of two days before I got in (this is where I had planned to put my initial stop), which, with slippage and all, would have been close to 400 points. When I raised my stop to the low of the day, my worst-case scenario hadnt changed, but my new stop would get me out beforehand. In either case, Im prepared for the worst, so it wont come as a shock should it happen.
M Y $ 8 , 0 0 0 N O O N E R
I remember one day when I was day-trading stocks and I had just started dating a girl who lived two blocks from my office. She called me up and said she was home from work that afternoon and asked me if I wanted to come over. I think I was out the door before I hung up the phone. I had maybe 10 long positions on at the time, which were all doing okay in a boring, sideways market. So I didnt think much about leaving them alone, besides, I had stops in them (though not tight stops). I put on CNBC when I got to her place just to keep track of the market, which didnt go over all that well. After about an hour or so, a report comes out about an anthrax scare. My first reaction was, Ah crap, Im gonna get killed. My second reaction was, Ah crap, how am I going to leave. Shes gonna kill me. I had my stops in, so I decided to stay. I later rushed back to the office where I had been stopped out of everything with an $8,000 loss (which was a big loss for me).
Though this is a scenario you can never really plan for, you always need to have the unexpected in mind and be protected should it happen. The worst of it was that it was a false scare and the market came roaring back up later. That feeling was even worse than her e-mailing me and saying I was a jerk and she didnt want to see me again. Anyway, the moral of the story is that if you are going to have a nooner, make sure youre protected.
Where Should My Stops Be?
As part of the scenario process, you need to constantly reevaluate where your stops should be. You need to ask yourself, Do I need to readjust my stops? This could be done to make them tighter so that you lock in a profit or take less of a loss. Or it can be done to move them away if the market calls for it, although its not a good idea to move stops farther away simply because you are close to getting stopped out. There are some situations where, after a day or two, you are very likely to get stopped out, even though you are still correct in your trading decision. Maybe its because volatility changed and your old stop became too tight. If this were the case, I would do one of two things. Either get out because conditions have changed, or change the stop to a proper level given the new volatility.
Most times though, you should look to move your stops closer. As you go through your different market scenarios, concentrate on where you will get out if the market doesnt go your way. One thing I want to note is that depending on the trade, I can have different stops based on the scenario. Lets say Im long the market and have a protective stop in. I also may have a system that gets out of a long trade if the market gaps open higher and then goes five ticks below unchanged for the day. In this case, I have my original stop, which is based on the reason I got in, but if the market does open higher then Ill have a new stop at five ticks below unchanged. If the market does not gap higher then this stop is not even put into play. If the market does gap higher but doesnt go negative afterward, then I revert back to my regular stop for the next day unless I move it for some other reason.
Is the Market Near a Stop or Exit Point?
The closer you get to your stop or exit point, the closer you get to action time. This is the time you have to really draw up the tightest scenarios to confirm what you want. Avoid the temptation to move your stop or target simply because you are close to it. But the markets are dynamic and change with the wind, so the target you had in mind two days ago, may be totally irrelevant today, and you need to make sure you have the proper scenarios of what it can do now. You need to be totally alert as you get closer to a stop area. In my example above, I knew the market was going to stop me out on the open. But I had a scenario that called for me to remove the stop for a half hour to see if I could get a turnaround. As long as you are disciplined to get out when that 30 minutes is up, I think its acceptable to do this. The problem comes when you do not actually get out when you say you are going to.
Should You Add to or Lighten Your Position?
This is one of the main reasons you want to draw up scenarios. Every day and every hour things change. The initial position you may have had may no longer be as strong or it may be stronger. By keeping abreast of the market changes you can be in a better position to lock in a profit, limit a loss, or see a new place to add to your position. The person who puts on a trade and then ignores it, is really only trading half-ass and putting on an unfinished trade. Nurture the trade and you will get a lot more out of it.
What Is This Indicator Trying to Tell Me?
Indicators not being a set-in-stone science, leave a lot to the what-ifers imagination. You can ask yourself, What will I do if the trend line gets broken? What if it holds? What if the five-period moving average crosses the 20-period one, while the RSI is rising? What if the stochastics indicators are oversold but stuck in oversold territory? What if they are rising and all of a sudden turn? What if the market breaks a 10-period congestion area? What if it breaks then fails? I can go on and on with this for the next 12 pages, but you get point. Make scenarios of whatever can happen and you will be so much more ready to trade them when they happen than if you came in blind.
Traders all have their things they look at when evaluating positions and there are many ways to come up with scenarios. I like to know the average true range (ATR) of the markets I trades. Ill know that if it stays within its average range I will think one way, but if it breaks it, the market is presenting a different scenario from how it normally acts, so I start looking at it from a different point of view. Some people like to know where the pivot point (the average of the previous days high, low, and close) is. They trade one way if its above the pivot point and another if its below, and yet another if it dances around the pivot point area. Whatever indicators you like to use, draw up scenarios as to how you would react depending on what they say.
What If It Reverses Midday?
Are you prepared for a huge reversal during trading hours? Though not an everyday occurrence, it does happen, and it can be violent. Ive seen several times where commodity markets go limit down and then reverse later in the day to go limit up. Ive seen the Dow be down 150 points at 2:30 P .M .
and then rally 300 points. Ive been on both sides of these days, where one minute Im down $12,000 and then end the day up $10,000 and vice versa, Ive also had a couple times where I played it perfectly and caught both moves. One that sticks out was simply using my multiple time frames and seeing a support line in the 60-minute chart that wasnt clear in the daily or five-minute chart and combining it with a stochastic indicator that just crossed over from oversold. The things I did best here was not get married to my position and included it as one of my market scenarios as the day unfolded. Its hard to predict these moves until after they are well on their way, as they start out looking like a normal dip or bounce in the giant move of the day. You could have a great short trade on and be down 150 points in the Dow, and before you know it, its only down 100 points and you are tempted to short more as you believe it is just a bounce and a new shorting opportunity. Then all of a sudden the market is down 50, then down 10 and then up 40, and so on until it closes up 150. These moves happen so fast you have no idea what hit you. Just know it can happen and have stops to help you avoid a disaster. You need to be able to think fast and reevaluate at the drop of a hat without being stubborn if it does.
This chapter ended up being longer than I had planned, okay a lot longer, so I guess it turned out to be more important than I had thought. Theres a lot to recap in it, but I dont want to make it much longer. So Ill just say, its really, really important to draw up scenarios of everything that could happen, before and after the market hours and then a few times during the day as well. Keep an open mind and try to be able to look at the markets from all sides. Yours is not the only opinion out there. Even if you trade the wrong opinion, you should know what the market can do and be prepared for it. The more you can imagine what it will do, the more likely you are to reduce your risk and capitalize on your trades.