Questioning Trading Rules

Whenever you talk to other traders, there is always someone who feels certain trading rules are gospel and other rules are foolish.

Sure, trading rules about cutting losing trades off at the knees when it’s hit the point that invalidates the premise is one that I can get behind.

Those rules are all about saving your trading account because once the account is finished, so are you.

But there are other rules that many trading courses talk about.

Rules that many traders hold dear and follow to the letter.

The issue becomes when you can’t see the folly behind buying into your rule and discounting other trading “rules”.

  • There is more than one way to make profits.
  • There is more than one way to enter a trade.
  • There is more than one way to deal with risk.

The issue is finding what suits you as a trader AND fits the trading style and plan that you have chosen.

I want to recreate a chat with two traders I had where each had separate thoughts on two popular variables in trading that we have all heard and read about.

Trading Rules For Profit Taking

Scaling out of your position as the trade goes in your favor allows you the benefit of taking profits and reducing your risk at the same time.

This chart here shows a trade entry that may or may not be a valid entry. This is for sample purposes only.

Trade Entry - Valid Entry

The trade rallies nice and the green line represents a higher time frame swing level. These areas do have a tendency to hold up price and if this move is a trend continuation, it should break the level.

We don’t know if it will break the level but we do know these levels do have volatility as different interests take action. A safe scale out that reduces risk is right before this area where you see “1st scale”.

You can see there were competing interests at the level as shown by the yellow box but buying pressure wins the battle.

Price makes a high but there is not structure to the left that stood out that would indicate there could be resistance. Price falls but then rallies again but this time, there is clearly a structure level where we could take profits.

As price rallies, it hits the high where you would scale out again (2nd scale). Clearly, this level had selling pressure (could it be others who use this level to exit longs?) which, depending on your strategy, could have you buying the lows when price starts to rally again.

The main issue people have with scaling out is that if you don’t hit the first scale out and price reverses, you get stopped out full position.

On the flip side, your profits are not full position profits because you have taken off positions while the trade was moving in your direction.

Fair points.

Using Limit Order Entries

The other trader in the conversation was not a fan of scaling out for the reason of less profits, full stop outs.

This trader stuck to his guns and actually called scaling out your trades “foolish behavior”.

He went on about his trade system which was, in brief,

  1. Use limit orders for entries
  2. Target structure levels for profits.

Pretty common basics that many trade plans call for but there is an issue that this trader didn’t think of while he was bashing scaling out.

I told this trader that his limit entries have issues that can have huge consequences on his profitability.

What is a limit order?
A buy limit for example is an entry order that sits below current price. If/when price reaches/trades through your entry price, you are filled. This allows you the benefit of having the market come to your price and not have you chasing the move.

Problem. Take a look at this chart.

Limit Orders

The line “a” represents resistance busted through and the trader sets a limit order in that area to catch the bounce. The stop is placed at “b”.

As you can see, the trade gets filled and then stops out for a full loss.

Here at “c” we have a trend line from the highs off to the left. A limit order is set at the line and what you can’t see, there is a small congestion area to the left that helped support this trade.

Price punches down to the area, misses the limit price and then rallies strong for over 400 pips before offering another possible entry area.

Do you see the problem?

While this trader bashes scaling out, he fails to understand that he will participate 100% in all losses as well.

However, he will not participate at all (at times) on large moves if price does not come to his area.

As a side note…if your trade plan uses limit orders for trade entries, have you factored in no fills into your testing to see if you have valid samples?

Keeping an open mind is paramount when choosing a trading plan, trading rules, and trading method. This one trader was so adamant that scaling out was a fools game that he totally missed the boat on the downfalls of his trading method.

There is nothing perfect about trading. There will be trade-offs in many aspects that you should account for when deciding on your plan of attack.

All of the trading rules and trading “truths” for the most part can be rethought and dissected as they pertain to you as a trader.

Question everything you hear.

Question everything you see.

Question everything you read.

For more updates from Mark and the team at NetPicks, be sure to visit their trading tips blog at NetPicks.com.