- 2000: Volume 9, No. 1 Pulling the Trigger

Day-traders and long-term investors have many differences resulting from their time horizons. Technical analysis may tell the former to sell and the latter to buy, but the one thing they have in common is the act of trading. In order to execute their strategies, whether they be long- or short-term, each has to put their analysis into action. The simple act of "pulling the trigger" to trade is the final step.

The Questions

Once all charts have been marked up with trendlines, studies and other technical tools, the technician needs to set the final criteria needed to trigger a trade. These factors include target price for a winner, stop price for a loser and price at which the trade should be executed. The opinion on a particular stock or commodity may be bullish, for example, but there are several questions that must be answered.

• What is the ratio of profit potential to loss potential at my target and stop prices?
• Am I trading with or against the trend of the next longer term?
• Should I trade at the current market price or wait for a better execution price level?

The first two are easy to answer if the preceding analysis was complete. The third question is the difficult one in the subjective world of trading. The answer depends on the timing of the analysis. If the technical breakouts or reversal signals have already been made, then it may be too late to trade that particular signal. It might be better to wait for the first correction before trading.

If these signals are about to happen (based on the analysis) then it may be too early for all but the most aggressive trader. However, if the signals have just happened, the best way to trade is usually at the market. We can assume that this last case will be the most relevant to the trader or investor who follows his market regularly.

No Fear

Once targets and stops are set and the trading signals are given, the technician can execute the trade with no fear. Losses are limited and projected profits should make the risk of these losses worthwhile. In general terms, if the profit potential is at least three times the loss potential, the trade is worthwhile. Keep in mind that like baseball players, traders who can win 40 percent of the time are leaders in their profession. The value of the six losers is far outweighed by the value of the four winners.

The Nikkei Index in figure 1 was in a significant bear market going into the start of 1997. After falling nearly 2000 points in one week, it began a rising wedge correction that lasted until late February when the index broke down. Short-term traders should have sold intraday during the big drop on February 28. Long-term traders might have waited until the close to sell, but let's examine why it was still a prudent trade.

Figure 1

Technical analysis showed that the long-term trend was down. The wedge size suggested a downside target of 17,550 and a reasonable stop level was the 18,875 resistance level seen throughout February. February 28's close was 18,557 so the profit target was roughly 1000 points. The loss at the stop price was just over 300 points. This is a better than 3:1 ratio and hence a good risk.

May NYSE Cotton futures in figure 2 broke above a descending triangle on March 7 on a small gap up. This should have immediately triggered a buy order at the close. The following day, the market gave back a few points in the morning before exploding higher. Failure to assess the risk/reward of the trade and then acting could have cost the technician the entire 100 point profit of the following day. The risk was essentially getting stopped out just below the trendline for no more than 75 points (ticks). Considering the size of the triangle (bottom line not shown), the profit potential was approximately 550 points.

Figure 2

This brings us to the scenario of the late analysis. The technician now needs to determine if the remaining 450 points of profit are worth the now 175 points of risk. This time, the ratio is below 3-1 so it might be better to wait for a pullback, reassess the trade and then decide.

To conclude, let's look at a losing trade and see that pulling the trigger to exit a trade is equally as important as it is to enter a trade. In Figure 3, the spot Australian/U.S. Dollar exchange rate broke below its technical support on November 7. This should have triggered a sell order. However, the next day, the market reversed, sending the pair back above the former support level; the predetermined stop price. The trade should have been stopped out immediately. In the three weeks that followed, prices soared.

Figure 3

Michael N. Kahn is a columnist for Barron's Online based out of Florida. He also writes a free technical newsletter. To subscribe to this service, please visit www.midnighttrader.com. The complete collection of Michael Kahn's "Tips on Technicals" is available in Real World Technical Analysis.