One interesting thing that I would like to point out is the linkage between different trade types. Recognizing this linkage helps with the issue of re-entry if exiting a trend trade early, and also ensuring consistency between the trading rules for trading a breakout / breakdown vs. flipping a trade.
Countertrend vs. Exiting Early
Say the current trend is an uptrend.
- If you did not have a position, and you take a short, that is a countertrend trade.
- If you have a long position, and you exit early (compared to what your trading system dictates), your exit trade is actually also a countertrend trade.
- In both cases, you are betting that the market will go down. In a way, a net short position is a more “aggressive” version of the countertrend trade, because you are willing to lose your original capital if you are wrong, whereas flattening a long position gives up potential upside if you are wrong.
One benefit of recognizing this link is that it helps to set the re-entry price for traders that still want to exit early. So when you take a countertrend short, you would likely place your stop just above the most recent high. The stop is placed at a level where you admit that your countertrend trade has failed. Since your early exit is also a countertrend trade, that same level is the spot where you should also admit that your early exit has failed, and hence you should get back on the trend again.
So when you want to exit early from your current position in line with the trend, immediately after you exit, place a buy stop just the most recent high. That defines and limits your risk for being wrong on your countertrend exit, and gets you back on board.
This should help to address a common issue where traders after they exit early from their trend trade, they freeze as price goes back on track and they are stuck in indecision as to whether or not to re-enter, and at what price to re-enter. This freezing on the re-entry decision in fact is exactly the same as freezing when faced with an increasing open loss, in this case, the open loss is on the exit trade that was just made. And as we all know, freezing as your loss increases is a recipe for disaster.
Breakouts vs. Flipping
Now just like initiating a countertrend trade is pretty much the same as exiting a trend trade, breakouts and flipping pretty much the same as well. A flip occurs when you exit your previous position due to being stopped out, and you enter a new position in the opposite direction. A breakout / breakdown trade occurs at the same price, except that you did not have a position prior, so you enter a new position in that opposite direction.
As both trades are the same, a few things follow
- The trade hypothesis is the same, you expect price to move off and not return back within the range / region prior to the breakout / breakdown. If you expect price to still go back into the region before continuing with the breakout / breakdown, then you would not have entered at the breakout / breakdown.
- The dangers for both are the same, it is susceptible to shakeouts, e.g. a spike up and quick pull back in, or a spike down and quick rebound back up.
- Their stops should be placed at the same spot. This is a good sanity check for those traders who have both flips and breakouts / breakdowns in their trading plan. In terms of stop placement, there are generally 2 approaches: one is to place the stop at a price level where price has gone back into the range / region prior to the breakout (i.e. the trade hypothesis is invalidated). Some people like to give the trade more room by placing the stop on the other side of the range, above the last swing high for a short, or below the last swing low for a long.