What's Your Tolerance?

Successfully navigating through the market's head fakes and reversals requires, above all else, a specific plan that establishes clear limits when price direction deviates from the intended direction. How far are you willing to drive off the paved road and into the deep jungle? The "off-road" experience may provide the reward of a shorter (or profitable) trip, or could potentially lead to the need for a search and rescue team. Without resolving this issue at the outset of each trade, second guessing and impulse reactions will ultimately lead to regrettable trading decisions.

Take a look at the chart below. Assuming you took a bullish stance and bought the market back at the left side of the chart. Is it time to close the trade, set the stop, or sit on the trade?



The only right answer is that the answer should already be known at the time the trade was initiated. The last five days were not so kind based on the long red candles that resulted in a 6.5% drop from the top. One opinion is to make the decision based on the recent market action, but this is not a substitute for pre-determining duration of trade and the extreme limits that the trade will often encounter.

Traders are often blind-sided by extremely fast market action including those unfair overnight gaps in price, but more often, they are caught off-guard by slow, eroding price action that seeps deeper and deeper to a point of no return...right before their eyes.

In hindsight, a longer approach worked out well. The longer term trader made the decision to ride the deeper troughs in anticipation of greater gains. The trader that cut losses at the first dip also retained a profit. The reasons for getting out of the trade may have been due to a pre-determined 8% loss limit. Profit taking at this point was pre-determined, and maybe a better risk/reward set-up was approaching in another trade.

(The charts below and above are actually the 2009 QQQQ's.)


With a clear view at the outset of each trade, a poor outcome may require a change to the method, but at least no excess energy is wasted on decision making when the market unexpectedly veers in the other direction. The overused axiom of "Plan the Trade, Trade the Plan" still rings true.