Define your management and exit rules. This is another very grey area for novice traders, and I’m afraid one that non traders write about a great deal, and sadly write a great deal of nonsense. Again, I am going to cover this in much greater detail when we start putting everything together, and the reason I include it here is simple. You do need to say within your trading plan how you are going to manage any position, and what your exit is based on - if it is purely discretionary then that’s fine and no problem at all.
Many trading books at this point will suggest a simple risk reward relationship and once that has been met then you exit. This sounds very simple in theory, but that’s where it stops - in theory! The practical is very different. After all, why should the market give you 20 pips if you are prepared to risk 10. Or 30 pips, or whatever target you have in mind. The market does not work this way and never will, which is why you have to be discretional in your trading management
and exit.
Let me explain with a simple example which combines the entry and the exit and uses the hammer candle, and the shooting star candle that we looked at in one of the early chapters.
Suppose your entry rule for a long position is a hammer candle and the associated exit rule is a shooting star. The opposite would be a shooting star for a short position as your entry trigger, and a hammer candle for your exit rule. A very simple rule set, which can then be applied to your trading timeframe which might be a 5 minute chart, an hourly chart or a daily chart. That is your rule.
Do you follow this rule blindly and without thought on each position? Well possibly, but I doubt it very much.
What happens when your entry rule, a hammer for example, is then followed on the next candle by a shooting star. Do you exit immediately? Probably not, and the reason, is simple. You have only just entered the position and your mindset is still in ‘hope’. You are hoping for a profit and not yet prepared to consider exiting at a loss after such a short space of time, which is one of the reasons these types of rules simply don’t work.
The corollary to this, is that you might say, well I will adjust the rule to say after X bars. In other words, if my exit candle appears within 1 or 2 candles from my entry, then I will ignore it under my rules. Very soon, your rules become discretionary, or very complicated!
Let me give you another example which is a common rule that traders apply when trading in a market that has a physical exchange with an open and close - stocks for example or an index future. The rule here is generally something along the lines of: ‘never take a trade in the first ten minutes of the open’. This sounds very plausible. In other words, let the markets settle down before taking a position. But why 10 minutes, why not 9 or 11 or 15 minutes? And what happens when an opportunity appears after 9 minutes and your rule states that no position is to be taken before 10 minutes have elapsed. Do you wait? Do you take it? Is one minute important? This is what happens when you put these sorts of rules into a trading plan, which is why I have a problem with them, and I hope that you can start to see why!
I’m going to cover this in more detail later in the book for you, but this is perhaps the one area that is the most difficult for new traders. The only rules
which are set in stone are your money management rules. Everything else is discretionary, they have to be. Traders who have trading plans which have no leeway will fail ultimately. The plan may work for a while, but market conditions then change, and the old rules no longer apply. It is rather like opening a shop and saying that today I want to make X. Well you may want to, but what if the weather is bad, the road is being dug up, it’s a Monday, or a shop close to you is having a sale? All these factors will play a part. Nothing stays the same day to day, and it’s the same with the markets. Every day is different, every day there are different forces at work, and to think that a mechanical plan will work consistently is somewhat naive.
Your plan needs to reflect this and needs to be practical. If you are going to take your signals after a break out from congestion, then say so. If you are going to do this in conjunction with a technical indicator, then say so. What your plan will not say is precisely when you are going to act. Equally, if you are going to exit when the market moves into a congestion phase, then say so in your plan and you will then need to explain how that congestion is defined on your chart. At least you then have a basis, a framework around which to work, and not some hard and fast rule set which is unworkable, inflexible, and probably much too complicated.
Don’t worry, if this doesn’t make sense right now, it will by the end of the book, but remember, I will be teaching you what I believe is the correct approach - you may disagree! But I hope I can convince you.