Saturday, September 11, 2010

Having the nerve to trust your system

Trend following in it's purest form means that potentially it is possible to lose all your initial risk stake on a trade after being in a profitable position. I've attached a chart of a trade on a UK small-cap stock I recently entered to show as a prime example (click on it to enlarge):

I will explain the lines - the thin green and red lines denote the 10 day high/low, the thick green and red lines are the 20 day high/low.

I entered this position on the open on 02 September, after the 20 day high was pierced, with the initial stop placed at the 10 day low. As you can see, the trade progressed in my favour until  07 September, where there was a gap up that has subsequently been closed, and then some. At the high point, I was showing slightly more than 2R profit (i.e. the open profit was twice that of my initial risk). As you can see, the 10 day low hardly moved since opening the position. This means that my inital risk of 1R is still fully at risk. As of Friday's close I am in a small profitable position.

It would have been very easy to have closed the position on the gap up, or have moved my stop up to some place in a technical 'no man's land'. However experience has taught me to trust my exit rules.

How will this trade turn out? I have absolutely no idea. All I know is that, based on my previous experiences and trading history, my system will come out ahead in the long run - this may turn into a profitable trade, it may not. If it doesn't, no problem - I will be one trade closer to having a successful trade.

I would say that, to reach these conclusions, it has taken me an awful long time, a lot of trading, and some harsh experiences. Part of it is accepting that you cannot get every trade right. Part of it is the knowledge that you can never time the exact top or bottom of a move, and part of it is the confidence that your trading history has given you in your own particular trading method.

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