Response to Stimulus
The trader will need to monitor and evaluate the degree to which the position responds to the underlying fundamental and technical motivators. It is possible that the trade will outperform the trader’s expectation, perform as expected, underperform, or have a problematic negative outcome or puzzling non-response.
Figure 14.6 Potential performance trajectories of trade performance.
It’s Working Too Well – Radical Outperformance
If the trader is in the enviable position of holding a position that has radically exceeded the profit target in a step-function move or at an highly accelerated pace, the only real question is whether to immediately exit the position and book the profit, or take the time to determine if something has fundamentally or technically changed such that the market is now capable of moving further beyond the goal. The danger in taking time for analysis is that the market may just as quickly reverse direction, potentially costing the trader some or all of the recently acquired profits. If the trader does decide to maintain an exposure, it would be prudent to consider lightening up by closing a portion of the position, adding a protective option position, and/or setting a tight rolling stop to prevent giving away windfall profits.
It’s Working Like It Should – Productive Response
If the trader’s position has reached the profit target set in the trading plan due to the anticipated evolution of the fundamental or technical landscape, then he should exit the exposure in as efficient a manner as possible, book the P&L, and start looking for the next idea.
It’s Not Working Like It Should – Underperforming
If the fundamental and technical landscape has developed as the trader anticipated and the market’s reaction was positive but decidedly uninspiring, the trader will face a challenging decision. It is possible that the market has yet to fully assimilate the new information and that additional gains may be forthcoming, but it is also possible that the incremental drivers were not nearly as impactful as the trader was anticipating. Unless the trader can make a compelling case that the new information is not priced into the market, it may be more productive to take the (small amount of) money and run while there are still profits to be had. If not, the trader risks being forced to make a decision on a breakeven or negative transaction, which is an altogether worse state of affairs.
It’s Slightly Negative or Not Really Doing Anything – Problematic
Positions that underperform or hover around breakeven through a productive fundamental or technical development are a warning sign for experienced traders. If the market can barely rally in the face of bullish information, the most logical explanation is that the overall sentiment is significantly bearish. This is problematic for a trader with the underperforming position, because if the market barely budges higher with bullish development, how far is it going to fall if something materially bearish occurs?
Slightly positive and break-even trades are psychologically easier to give up on, as the trader can exit with only the opportunity cost of utilized limits. Slightly negative positions are the bane of every trader’s existence. It is all too easy to hang on to a small loser in the hopes that some unspecified, to-be-determined event will push prices back in the trader’s favor, allowing an escape at breakeven. This is a trap. If a trader is unwilling to take a small loss on a position, the reward is usually a large loss realized at a later date.
Maintaining an unproductive position can be hazardous and expensive. The longer the trader sits on the position, waiting for something beneficial to happen, the greater the chance of an exogenous event impacting the market. Even if the market remains docile, there are nontrivial credit and collateral costs associated with holding a position. Paying rent on an unproductive exposure while waiting for a black swan to make things bad enough to exit is foolish.
From Chapter 14 - Managing Positions & Portfolios, Pages 544-546.
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Excerpt from Trader Construction Kit Copyright © 2016 Joel Rubano. All rights reserved. No part may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without permission in writing from the publisher, except by reviewers, who may quote brief passages in a review.