Setting Time Stops: Knowing When To Exit Drifting Positions

You’ve entered a position on the basis of a good-looking setup. You know that most of your past winning trades have tended to move right away. You watch, but this one stays flat, not just for a few bars, but for hours. You end up holding the position overnight because you believe in it so much. Two weeks later, with the position still drifting, you’re wondering what to do. 

Sound familiar?

Suppose you bought Robert Half International (RHI) on the gap breakout, and watched the stock drift.

Originally designed to be a daytrade, the position has gone nowhere for two weeks, and all of a sudden you’re a swing trader.

How do you decide when to pull the plug?

Whenever you enter a trade, you should anticipate and have a Plan B, Plan C, Plan D, etc. for all possible outcomes. Where is the trade going? What are your expectations? 

Think in terms of your upside, as well as downside potential. Many traders use a minimum risk/reward ratio of 2:1 as a guideline, ie., willing to risk $1 to make $2. (This obviously doesn’t mean you have to exit with a $2 gain, it is simply used as a rationale for taking a trade or not).

Risk/reward profiles vary with each setup. Consider the head-and-shoulders pattern in Example 2 (DNA). Calculating twice the distance from the top of the head to the neckline, you'd look for a target price of between $60-65; in fact, this setup worked beautifully, making a low of 64.  A rally above the neckline would have been a clear warning to get out.

Or look at the breakout from a pullback in Example 3. On the pivot from the pullback, you could reasonably expect a swing move several points above the previous highs. On any failure, however, you would want to get out quickly.

It's About Time

Life would be rosy if all you had to think about was the upside, but trading requires you to think more deeply than that. Obviously, when you enter a position, you temporarily tie up capital that could be used for other trades. The opportunity cost of entering one trade is that you can’t simultaneously enter another. In this case, you have a drifting position tying up precious trading capital that could be used to make money. 

Keep in mind, any time you enter a position, several factors determine your risk in any trade:

        1.  size of position

        2.  volatility of underlying security

        3.  pre-determined stop orders

        4.  time in market        

One of the main premises behind daytrading is minimizing time in a given position and avoiding day-to-day price gaps. When you hold a position overnight, you’re ignoring this concept. By increasing the time in a position, you’re automatically increasing the probability the trade will blow up through bad news, overall market action, etc. Not only this, but the mental energy expended worrying about a drifting position is a real drainer and can temporarily hurt your trading.

A good way to put yourself in a more time-critical state of mind, consider the plight of the options buyer. He must not only be correct on price movement, but within a specified time. Time value is constantly decaying, making the position increasingly risky. During the last two weeks before expiration, time value erodes very quickly. Option buyers must look for especially explosive setups to overcome this disadvantage. Thinking in these terms, a position held a couple of weeks seems pretty risky.

On stock trades, I like to imagine that every trade I put on has an expiration to it. Usually the expiration is tied to some pattern that has given me an entry. I look at the pattern and, subjectively, estimate how much time would need to pass before the pattern is invalidated. This expiration varies from pattern to pattern and also is adjusted on the basis of market technicals. Sorry that I used the word "subjective." Many people in this business hate it. But I have spoken to a number of professional traders about this and they, like me, do not have any specific parameters they use because there are many variables involved in determining the length of time they'll spend in a trade and it's simply not as cut and dried as setting price stops. But I have accomplished my purpose in this article if I get you to become conscious of the risk exposure that comes along with amount of time you spend in any given trade. Want to know more? Dave Landry talks about time stops in Part II of his Position Management Series.

Of course, if you're getting antsy about the length of time you're spending in a trade, you can tighten your stop-loss instead of exiting the position outright. This will allow you to hang on to the opportunity in case the Cavalry rides in to save the day. 

Picked correctly, your setup should become profitable soon after entry. If it isn't, try raising your protective stop; move it up to force a trade on a downtick. Or try a sell stop one or two ticks above the ask. (Be careful the stock suddenly doesn’t swing and you end up selling twice!)

Some ideas:

        --    If it doesn’t feel right, get out.        

        --     Pretend it’s an expiring option.

        --     Adjust your stops to force a trade.

In general, you should immediately get out of a position that’s not moving. Many times it just doesn’t feel right and the decision is easy. It usually means there is something wrong with the stock, and you don’t want to be in it when it breaks down. That doesn’t mean, however, that the setup won’t work out later. Sometimes stocks do a "head fake" before following through with the anticipated move. Many times, the second trigger is the real thing.  

Being a good trader is not just about trading--it’s about watching, waiting and patience. Keep in mind, though, that there are two kinds of patience: smart and stupid. Smart patience is waiting for just the right setup; stupid patience is wishing and hoping a position will move. 

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