Method 4 The Technical Indicator Stop

Another way to place a stop would be to use a technical indicator to help you establish it. Going back to the first gap day you can say that if the stochastic dips below the recent low in the stochastics (horizontal line in Figure 12.5), you will get out. This type of stop makes it the hardest to mea-

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sure how much you will actually lose. But with enough trading experience you can get a decent idea of the relationship between the market and the indicator and what it will take to get it down there. I think about 3 or 4 more 30-minute down bars and it will reach that point, possibly costing up to 200 points.

If I had to choose one of these methods for exiting this type of gap trade, I would use the first one, but I would be abreast of the other factors and exit if the trade did not seem to be working.

ANOTHER TRADE

This isn't the only day-trade you can find in the last two days. Let's assume you took the gap trades and exited when the gaps were closed in both situations. My first reaction would be to go short because we are in a downtrend and just closed the gap. The news of the rate cut wasn't a major factor to me because the market completely shook it off by opening lower, and I believe the subsequent rally was a normal technical reaction to a gap open.

Let's say I shorted (Figure 12.6) at point S1 as soon as the gap was closed and the stochastics crossed out of the overbought area. This would be at about 12,050, with the target being the lows 400 points away. As a day trader I would place my stop above the congestion of the end of previous day shown in the gray box, or use the stochastics to tell me I was wrong or I could place a stop above the trend line of the last two days.

I could also use a 30-minute chart or a 60-minute chart to come up with a stop. For this trade I'm going to start my stop above the congestion area at 12,220 (Stop 1) and plan to move it down as the market goes down. I'm currently risking 200 to make 400 and I'm going with the major trend so I like this trade. The market went sideways to down the rest of the day testing the high two other times. It was a good day for traders who like looking at oscillators but I'm sure many people bought the peaks and sold the bottoms at each move. As I look through the day's action it is most likely I would have stayed short until the end of day, as I would not have been stopped out.

A CRAZY DAY

When I started writing this today the market was where Figure 12.6 leaves off. Luckily I don't have time to day-trade much until I finish the book, and I'm happy with my short position. But today is the kind of day people can get their heads handed to them.

I'll use the high of yesterday as my initial stop (Stop 2) for any shorting situation. I could adjust it when I get in again or as the market moves, but my worst-case scenario would be that. Let's say you wanted to short at point S2, when the market broke below the day's trend line. Depending on your style you could have placed a stop at Stop 3 or Stop 4. The more of a winner you are going for the more room you can give yourself. What you cannot do is give yourself 200 points if you're looking for a 50-point winner. I personally would have set my sights first for the low of the day and then yesterday's low.

As the short started working I would consider adding to it as it broke the lows of the day and moving my stop down with the recent trend line it was making. Yes, the Dow was already down 300 points but it's been in such a bad tailspin lately and it couldn't hold the rally yesterday and volatility was blowing up, so I believe it could still go lower. But as a day trader you need to be careful about just how much lower you think it can go. This is all about drawing up scenarios and the closer you get to the target the better those scenarios should become. Yes, there are some days when the market will drop 500 points or so, but that's happened what? A handful of times in history. Odds are not likely you will get that kind of a huge move, but on the other hand the market had all the ingredients for it to do it now. It's a tough call to add to the position when the market is down 300 points, so I would have chosen against it. But if I had added to it, I'd be diligent about a tight stop in case I was wrong.

Anyway, where Figure 12.6 leaves off I sat down to watch TV with my almost two-year-old daughter and though it was a riveting episode of "SpongeBob" we were watching, I fell asleep on the sofa. When I woke at about 3:30 I was shocked to see what the market had done during my nap. From being down 300 it was approaching being up 300 points. Look at Figure 12.4 or Figure 12.7 and you'll see this incredible late-day rally. I was also shocked to see how much damage one unsupervised toddler with one yellow crayon can do before she eats half of it trying to destroy the evidence.

This is one of those days where if you do not have a stop, you can get destroyed in the market by not paying attention. You can also get hurt by repeatedly shorting throughout the rally thinking that the up wave was ending any minute now. If I had been out of the market, I know I would have looked to get short at points A and B (Figure 12.7), thinking it was the greatest setup for a trade, using the stops from earlier in the chart and boy would I have been wrong.

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Forget about the market, the one thing I really did need to do was come up with a good excuse to give my now even more extremely cranky unemployed girlfriend whose stocks haven't been doing so hot lately and who was just coming back from yoga, as to why the walls and Siena's tongue were yellow. Luckily, Crayola makes nontoxic crayons that come off the walls with a little WD-40. Not having a good excuse, I then needed to go over my real position of being short for the last two weeks. I had just given back almost 600 points from the peak value of the day, and that is a lot of "paper" money to give back. I would never enter a trade with a 600-point stop, so I don't like giving that much back, but I do have to consider the volatility of late. The market was still below my stop level but that kind of bounce needed to be reevaluated. This is the kind of day that can end up being the turning point in a market's major direction. I wanted to make sure I didn't miss anything, and so I needed to review the trade in all the time frames. I'll go through this in the next chapter. By the way, the stops in Figure 12.7 are for day-trading purposes, not for my longer term trade.

I'm sure if someone else was writing this book he would use this chart to show you the perfect market setup in hindsight and how he captured the whole move from point A or even better, and what you could have done to do so as well. That's why I think a lot of books are a bunch of crap. Yes, if you look at enough indicators with optimized parameters you can show how to catch this move from the bottom, but I think I'm one of the few authors you'll find to admit that he was wrong. I was napping so I don't know what I would have done at the bottom. I can see the crossover in the moving averages and stochastics indicating a buy, but I know for sure I would have been shorting aggressively when the market reached the trend line and had its little dip. And I would have been stopped out above that trend line and most likely not have gone long because I'm thinking bearish, and I'd think the up move was probably out of steam and I'd probably short again.

One last thing I need to stress, if you are actively day-trading, wait for the market to close to take a nap or you may just miss something.

PLANNING YOUR TARGET

Knowing where to put a stop is only a piece of preplanning an exit. It's the defensive part of trading and it saves your butt. But if you are going to make money you need to know how to get out with a winning trade. Again, you start thinking about this before the trade is even made. As you are contemplating a trade and you have figured out how much is at risk, then look to see how much you can make. This is much harder to do then picking a stop. A stop is a worst-case scenario that you can see by looking at a chart, it is a fixed amount you are willing to lose. But a target is a guess that you hope the market can achieve. For example, I showed how grains were at all-time highs. There is nothing to tell you just how much higher they may go. You can maybe measure waves and have an estimate as to where the next wave is going to be, but this is a pure guess. You can have a back tested strategy for the Dow and know on average the winners are 800 points. But this is an average of 50-point winners and 2,000-point winners. And again, it's just a guess. You may be long crude because of a certain thing like an increase in demand from China. You don't know when that demand will die down or if there will be enough supply to meet it. So how do you get an estimate? You look for technical support and resistance areas, you use trend lines, Fibonacci numbers, Elliot wave theory; you can use a variety of technical indicators and most of all you guess. Even if you are wrong, at least you have something to work with. Me thinking the market may drop 2,000 points is just a guess based on a support level and measurement of a wave. I have no idea if it will get there, but at least I have something to base my trade around.

HOW WILL YOU EXIT?

When you plan your exit you also need to plan how you will exit. If you are working with a purely mechanical system, you really don't need to think much, just enter the orders and let the trade do its thing. It will get you out when it's ready. But when you think your trades through, like I have, you need to know what it is you are looking for to get you out of the trade. Is it the end of a drought? Is it when the market goes down for three days in a row? Is it when you get an outside reversal day? Is it when the market goes below its 50-day moving average? Whatever it is, you need to know this in advance. Yes, you can and should change your opinion once a trade is on and the market gives you more information to work with, but at the beginning you need something to go with. You need to know if the trade has room to work and is worth the risk you are about to take by putting it on. Consider the long trade I made a few chapters back. I really thought the market had room to go to new highs and this justified the risk I was taking. I was wrong, but so what? I still managed to make some money. I realized the market wasn't going to get there so I had to rethink. But if I was just long because I thought the market was going up with no thought as to where, then I don't know if I would have been able to tell I was wrong.

THE IN-BETWEEN AREA

Next comes what is the most likely scenario and that is the gray area between your stop and your target. The stop should be a last resort method of getting out, but if the trade is not working you should be out before it gets there. You also need to consider what will be your exit if your target is not reached. Here is where money is made and lost most often. You made what was a well thought-out trade, but now it's not working entirely as you planned. You need to realize it and get out. It doesn't matter if your stop or target hasn't been reached. I have stated several times that you should get out when the reason you got in is no longer there. You need to exit when the trade tells you to. Getting out of a small loser is one of the hardest things for a bad trader to do. He rationalizes that it's not a lot of money, it's better than it was an hour ago, he wants to at least cover his commissions, and he has a stop in place. Once you can learn to let go of a nonworking trade, you can move on. Bad traders are scared to take a little loss, and I've found it's one of the hardest things to get people to overcome. But learning to lose is crucial. I read somewhere once that losses are to trading like exhaling is to breathing; it's just part of the game and it needs to become second nature to you as you can't do one without the other. Trading is not about how much money you made or lost on one trade. It's about how you did over the course of a time period. If you can get $1,000 more by taking a winner before it retraces or a loser before it gets stopped out, and you do this repeatedly, you will increase your odds of making money.

Another scenario is that the market is getting close to the target and looks like it will go right through that target. I consider this as a new trade that you have to rethink everything for. You don't need to get out and get back in, but you need to think about it from scratch. You had a goal and it was reached, now what? Am I overstaying my welcome? Is the market still looking good? Was my target too close? Do I want to let it retrace a bit? Do I need to move my stop? How will I make sure I do not blow this and give back my profit? It's a lot to think about, but if you are going to stay past your target you need to reevaluate the trade.

CLOSING THOUGHTS

Just as I spend quite a bit of time planning and looking at different time frames and scenarios to get into a trade, I do the same when I exit it. I don't just get out on a whim. I need a reason to do so and then I evaluate and draw up scenarios the same way I would as if it were the start of a

Just as I spend quite a bit of time planning and looking at different time frames and scenarios to get into a trade, I do the same when I exit it. I don't just get out on a whim. I need a reason to do so and then I evaluate and draw up scenarios the same way I would as if it were the start of a new trade. Don't take the exit with any less seriousness that you would the entry. I know I wasn't very specific in how to actually pick stops and profit targets—I did that all in my first book—this chapter was more about why you need to do it and how you should plan getting out of trade. If all you get out of it is that you need to spend more time planning your exits than your entry, then I've done my job. Oh, and don't fall asleep when your toddler has a crayon handy.

CHAPTER 13

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