Real-World Example: When A Bad Trade Becomes A Good Setup

To me, a good trader is not one who is always profitable or always wins, but it is also one who learns from his or her mistakes. While a trading error can be expensive, it is necessary to look on the bright side; it's a learning experience. This is one of the expenses of our trade, no pun intended

Live and Learn

Each time that I take a loss on a trade, the first thing I do is look back at the trade and figure out what went wrong. I ask myself the following questions:

1. Why did I take the trade?
2. Did it meet the requirements of my trading technique and systems?
3. Did the pattern fail?
4. Did I stick to my plan?
5. Did I look at different time frames before opening the position?

To answer these questions, I look at my entry point and my exit point and determine why each of them was chosen. If I determine that my entry was a result of an attempt to catch momentum, but without seeing any setup, or if my exit was a result of fear, then I immediately know what went wrong. Rule number one: Only take a trade when you have a reason to trade.

A key problem in trading is sticking to the plan. Most professional traders have found some sort of trading system or technique that works for them. Losses are often a result of trading outside of the plan.

Moreover, I find that the biggest reason traders go out of business is because they do not stick to their plans and they do not adhere to their stops. From my own experience, as you may have read in my interview in The Best: Conversations with Top Traders, I can tell you that nothing is more detrimental to a trader's mentality and account balance than letting a bad trade get worse.

Getting Back To Good

Something that I have learned from my experience in the futures market is that it is not hard to turn a bad trade into a winner. In the futures market, it is easy to go from short to long or long to short. For example, if a trader is long two S&P contracts, he can sell four contracts and instantly go short, all in one transaction.

In the stock market, it is crucial to keep the same mindset, because often a bad long position will make a good short position, or vice-versa. This is because many of our trades are actually countertrend. For example, when buying pullbacks, a trader may be buying into the dip. In the case of a breakout, if the breakout fails to set new highs, and retraces, it would likely be profitable to be on the other side of the trade.

Real-World Example

Recently I was looking for a long opportunity based on a five-minute chart of the e-mini S&P futures. The futures had been trending upwards since the low from the previous day. After trading within a channel for 12 price bars, I was shopping for an entry based on the next bounce off the trendline. As I was about to transmit my order, I noticed that the next price bar traded outside of the channel that I based my entry on. I paused.

This price action reminded me that I had not examined different price charts for resistance levels. Quickly, I turned to a bigger picture chart to make sure that I had trends in two time frames in my favor. With just one glance, I quickly saw that the true trend was in fact down. The short-term rally on the five-minute chart was simply a small countertrend bounce off the bottom trendline. I pulled my order and did not take a position.

Looking at the chart, I quickly realized that, in fact, this was a more ideal short opportunity. The combination of the futures hitting the top of the 60-minute downtrending channel and the break of the five-minute uptrending channel resulted in a beautiful setup. All morning I was looking to go long, but in only a few moments I realized that it would in fact be a short opportunity.

My interpretation of the charts was in fact correct. After the futures broke out of the channel, they moved almost 30 points lower, making for a very handsome short play.

The Moral of Story

There is nothing wrong with making mistakes in your trading. It is often said that to be a professional trader only needs to be right 30% to 40% of the time. This is correct, so long as you cut your losses short and let your winners run.

Once you cut your losses, it is time to move on to better opportunities. Some of your best shorts may result from bad longs. Turning a bad trade into a good setup is good for both your mentality and your account balance.

Most importantly, learn from your mistakes, and do not allow history to repeat itself.

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