When we don’t have a plan, our emotions can suck us into strong market action. Unfortunately, most of these entries do not display favorable odds. Instead, we tend to follow Masters Greed or Fear right onto the plastic surgery table where Dr. Market proceeds to give us an expensive face-lift.
Last week I made a lovely scalp trade during a powerful short squeeze. The chart below shows I had a predefined entry point (A) in the event that the market popped in the final hour. As a result, I also had a predefined stop-loss point (B) and a $51 target which gave me a 2-to-1 reward-to-risk ratio. Thus, I was able to enter safely, take some quick profits into the initial move, and take the remainder at my target.
Now, let’s compare the above planned trading to unplanned emotional trading. Let’s say I saw the shorts squeezing and started getting excited. I did not preplan any entries or stop losses, so I was most likely late to the party and did not know whether the trade displayed the minimum 2-to-1 reward-to-risk ratio needed to be profitable over the long term. As a result, I would not know when the trade was too risky and taking the trade could cause more harm than good. Suppose I followed my William Wallace alter-ego straight into battle and entered closer to $50.70. Then, the Brits flanked me:
This is what we call “chasing” a move. You never want to chase a move because once most of the reward for other traders has been made, a growing number of them will be getting out of their position to lock in profits. In this example, we would have gotten our faces ripped off as profitable traders ran for the emergency exit.
I am writing a more thorough article on the importance of planning trades. Stay tuned …