When Should You Let a Winner Run?
04/26/2013 9:00 am EST
"Let your profits run" is one of the most quoted yet misunderstood trading adages, and Marc Principato of SMB University Forex Training Program explains how you can determine when to do that.
You know the following situation well: You had a long in EUR/USD at 1.3005 and sold it at 1.3018 only to watch it go to 1.3086 over the next hour. Of course, when you try and hold for these type of moves, you give back your 10+ pips plus some additional when your stop gets hit. How do we know when to hold for a larger move? In other words, when do we let our winner run?
The real question you have to consider is this: What is the significance of the price area where you are initiating your trade? Newer traders lack the experience and ability to gather the most relevant information from the market and as a result have no point of reference to make informed judgments. Understanding the relevance of your entry price begins with the quality of the analysis that you conduct before you initiate the trade. And if you do not have a well-defined framework to conduct your analysis, then you will have no sense of the potential for your trade. The professional trader has the type of trade defined before entry: it may be a scalp, a day trade, or a swing trade. So what can guide our decision?
One of the pieces of information that I examine carefully when I am analyzing price action is the category of price formations on the larger time frames in the price region of interest. For example, let's say my analysis indicates that the EUR/USD is at a major support level. How do I know it's major? Price action history will tell me that. So let's say EUR/USD is trading around the 1.3000 area. After a few hours of price action here, I recognize a double bottom on an hourly chart, which is in the process of forming. Price is attempting to push the low. In this scenario, I will be looking for signs that this low is being rejected like a long tail on a 30-minute chart, or a 15-minute bullish close. I can also look at the volume in the futures market to determine if there are any additional arguments in my favor.
If the formation holds up on the larger time frame, then I can try to further refine my risk by waiting for a setup on a 5- or 15-minute chart. Or, if I am ok with the current reward to risk ratio offered by the hourly setup, I can initiate the trade. Since the trade idea originated from a larger time frame, and since the trade is being validated on the larger time frame, as the trader, you should recognize that this trade has greater potential. It is reasonable to have a higher expectation for this trade. So in this case, if you exit quickly for a scalp because of some price noise, it means you are not aware of what the bigger picture is telling you here.
Compare this scenario with the following: Watching price action on a smaller time frame, you determine the intraday momentum is dramatically bullish. This means almost vertical. On your smaller time frame, you notice a small consolidation over a 30-minute period. As it breaks out to the upside, this would be a good candidate for a long. When you look at your larger time frame though, you realize price is near an important pivot resistance area. Is this the kind of trade that you want to hold on to for a long period of time? Hopefully you answered this question to yourself. This type of trade has little potential since much of the move has already played out. You are getting long near a potential top. This is when you want to think as a scalper and grab what you can. The thought process here can be further refined by the characteristics of the bigger picture as well. Are you long near a top of something that is generally strong? Or is the upcoming resistance a potential lower high? This should also weigh into your judgment as far as how much you should expect. In the forex market, 10-15 pips is a good target for trades that are not being initiated at a particularly important level.
Less experienced traders usually treat every trading opportunity with equal expectations, when in reality, each opportunity is unique and must be judged separately. Some trades offer more potential than others and having the ability to make these judgments quickly is what separates the pros from the amateurs.
By Marc Principato, CMT, Director, SMB University Forex Training Program