Monday, January 17, 2011
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I contend that the exit is more important than the entry. This insight took almost 2 years of trading time to understand!
In this post, I'm going to show you my technique for how I exit a "long" (i.e have bought to profit from price going up) short term and medium term trade.
Please note that this method works well on my "Seven" - I know it doesn't work well on mining stocks outside of the ASX100 or 200, which have different volatilities than the "blue chips". This methodology also only works in the current sideways market environment - you have to adopt new techniques for outright bull markets.
There are 3 schools of thought with taking profits: don't (buy and hope), sell into strength (i.e sell on a good strong up-day) or ride trend until it tells you to get off. I do the last as much as possible, but sometimes I go with my gut feeling and sell into strength. So far this hasn't worked out, as I've left lots of profit on the table, so I've structured my sell to be as disciplined as possible.
My Methods
Short term trend - I'm trading a short term trend, and have been riding the trend for about 5-10 days. I'm sitting on an okay profit, but am wary about future price action. My "sell-sell-sell" internal indicator (my gut) tells me I need to take a profit, but what does the price tell me?
The biggest sticking point is seeing a down "red"-candle day on your charts - say the price dropped 0.5 or even 1% or more in a day? Should you get out? If this happens, I look at the following four signals:
If all four signals occur, I exit. This works about 75-80% of the time and subsequent price action confirms I covered my profit at a good time. Unfortunately, sometimes it will rebound the following day.
Medium term trend - as above, but I add a fifth signal, with a close below the 15 day EMA. Again, sometimes this doesn't work and the trend starts again after a short correction. As I only watch 7 stocks, I am watching for these new opportunities, and have time to analyse the long term price action, which may still indicate a structural uptrend is still in place. There is no crime or shame in re-entering a trend after you have exited. The markets are amoral on this point.
A sidenote on indicators: these work for me as I have a low tolerance for holding periods (I average less than 20 days on directional trades), but may not work for other stocks or strategies. I have other systems I watch in parallel, as I get ready for markets to change behaviour. Current price activity (since around August 2009) is very hard to trade from the directional side - this may change in the months and year's ahead!
Price Patterns
There are distinct price patterns that can also indicate the end of the trend. I will cover two here: the bearish engulfing candle and the "inflation" pattern.
The "inflated" price pattern, which resembles an arc - works on both short term and very long term price activity, as it is a direct reflection of the participants. It usually starts with a breakout from a previous correction and then the "bubble" is pumped full of air before reaching a flat-line point.
The classic "inflation" is March 2009 to May 2009 (see the Dow Jones chart below). This fits a curve very nicely - remember to use semi-log scale charts, not simple linear charts for long term analysis. I only use linear scale on less than 3 months daily charts (but not for options, which can leap several hundred percent in days).
But this pattern works well on very short term activity too. The chart (below) shows a recent short term trend for Commonwealth Bank (CBA). The blue and red lines are the 7 day EMA, but based on high and low of the day respectively.
The black line is a fitted curve showing the "inflation". Of course, this can only be fitted perfectly, after the fact, but during a trend gives a good indication of current price action.
The crest of this pattern is known as an ascending triangle (see above), usually quite bullish. Indeed, price may go sideways for a while and then breakout and start a new, more linear trend.
What you are witnessing - in both the short and long term - is the behaviour of market participants, which may or may not be a reflection of fundamentals. Its all perception - what I do is read perception.
Bearish engulfing candle - (see diagram right) - is very easy to explain. A quick primer on candles, they are just a fancy way of showing the high (upper "wick"), the low (lower "wick"), the open and close of that day's (or week or month) price action. If its a down day you get a black or red candle, and the top is the open, the bottom of the candle is the close. For an up day, vice versa (white or blue).
With the bearish candle, you are witnessing a new opening high, but then sentiment changes during the day and a sell-off begins. Finally, the low of the day is below the previous day's open (and low), "engulfing" all price action.
I don't like to rely solely on single day price action, but in this case, the bearish engulfing pattern does work extremely well. Combined with my above four (or five for medium trends) its a clear signal to get out of town.
Summary
Exiting a trade is more important than the entry - this is where you make your money on directional trades. Picking tops and bottoms is best left for monkeys, although the occasional monkey can profit using other strategies from time to time.
Don't feel bad if you exit early and then watch the price shoot up again. Re-enter. There is no shame in this: you have not misread the prevailing behaviour of the participants, but the non-participants. Think of it this way, there might be some on the sidelines watching a new trend develop, are cautious about entering, and then take the opportunity when there is a modest sell-off.
I know this - because its a major strategy I use to enter trades for my super fund, where my time horizon is much longer. Keep this in mind and don't beat yourself up if you watch the trade runaway!
Exiting a trade
In this post, I'm going to show you my technique for how I exit a "long" (i.e have bought to profit from price going up) short term and medium term trade.
Please note that this method works well on my "Seven" - I know it doesn't work well on mining stocks outside of the ASX100 or 200, which have different volatilities than the "blue chips". This methodology also only works in the current sideways market environment - you have to adopt new techniques for outright bull markets.
There are 3 schools of thought with taking profits: don't (buy and hope), sell into strength (i.e sell on a good strong up-day) or ride trend until it tells you to get off. I do the last as much as possible, but sometimes I go with my gut feeling and sell into strength. So far this hasn't worked out, as I've left lots of profit on the table, so I've structured my sell to be as disciplined as possible.
My Methods
Short term trend - I'm trading a short term trend, and have been riding the trend for about 5-10 days. I'm sitting on an okay profit, but am wary about future price action. My "sell-sell-sell" internal indicator (my gut) tells me I need to take a profit, but what does the price tell me?
The biggest sticking point is seeing a down "red"-candle day on your charts - say the price dropped 0.5 or even 1% or more in a day? Should you get out? If this happens, I look at the following four signals:
- close breaks uptrend line
- close below 7 day LO-EMA (more on this below)
- short term momentum closes below own smoothed average and/or 2% signal line
- short term cyclical was above 100 (which indicates a continued trend), and then turns below 50
If all four signals occur, I exit. This works about 75-80% of the time and subsequent price action confirms I covered my profit at a good time. Unfortunately, sometimes it will rebound the following day.
Medium term trend - as above, but I add a fifth signal, with a close below the 15 day EMA. Again, sometimes this doesn't work and the trend starts again after a short correction. As I only watch 7 stocks, I am watching for these new opportunities, and have time to analyse the long term price action, which may still indicate a structural uptrend is still in place. There is no crime or shame in re-entering a trend after you have exited. The markets are amoral on this point.
A sidenote on indicators: these work for me as I have a low tolerance for holding periods (I average less than 20 days on directional trades), but may not work for other stocks or strategies. I have other systems I watch in parallel, as I get ready for markets to change behaviour. Current price activity (since around August 2009) is very hard to trade from the directional side - this may change in the months and year's ahead!
Price Patterns
There are distinct price patterns that can also indicate the end of the trend. I will cover two here: the bearish engulfing candle and the "inflation" pattern.
The "inflated" price pattern, which resembles an arc - works on both short term and very long term price activity, as it is a direct reflection of the participants. It usually starts with a breakout from a previous correction and then the "bubble" is pumped full of air before reaching a flat-line point.
The classic "inflation" is March 2009 to May 2009 (see the Dow Jones chart below). This fits a curve very nicely - remember to use semi-log scale charts, not simple linear charts for long term analysis. I only use linear scale on less than 3 months daily charts (but not for options, which can leap several hundred percent in days).
 |
| The "Bernanke" curve - a classic reflation. |
But this pattern works well on very short term activity too. The chart (below) shows a recent short term trend for Commonwealth Bank (CBA). The blue and red lines are the 7 day EMA, but based on high and low of the day respectively.
 |
| note fit of curved (black) line and 7 LO (red line) |
 |
| from Chartpattern.com |
What you are witnessing - in both the short and long term - is the behaviour of market participants, which may or may not be a reflection of fundamentals. Its all perception - what I do is read perception.
Bearish engulfing candle - (see diagram right) - is very easy to explain. A quick primer on candles, they are just a fancy way of showing the high (upper "wick"), the low (lower "wick"), the open and close of that day's (or week or month) price action. If its a down day you get a black or red candle, and the top is the open, the bottom of the candle is the close. For an up day, vice versa (white or blue).With the bearish candle, you are witnessing a new opening high, but then sentiment changes during the day and a sell-off begins. Finally, the low of the day is below the previous day's open (and low), "engulfing" all price action.
I don't like to rely solely on single day price action, but in this case, the bearish engulfing pattern does work extremely well. Combined with my above four (or five for medium trends) its a clear signal to get out of town.
Summary
Exiting a trade is more important than the entry - this is where you make your money on directional trades. Picking tops and bottoms is best left for monkeys, although the occasional monkey can profit using other strategies from time to time.
Don't feel bad if you exit early and then watch the price shoot up again. Re-enter. There is no shame in this: you have not misread the prevailing behaviour of the participants, but the non-participants. Think of it this way, there might be some on the sidelines watching a new trend develop, are cautious about entering, and then take the opportunity when there is a modest sell-off.
I know this - because its a major strategy I use to enter trades for my super fund, where my time horizon is much longer. Keep this in mind and don't beat yourself up if you watch the trade runaway!
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