What To Do When A Trade Moves Against Us

Folks, there seems to have been a bit of confusion on the IWM trade setup and follow-through analysis. So I am going to address it here in a new thread to make sure that everyone is clear on the best practice on how I set up these trades and manage their follow-through. 

First and foremost when I set up a trade they are designed to be set up as the premium paid is your risk. There are no stops on these trades. So when entering the trade decide what you are willing to lose per trade and that is what you purchase in option premium. 

So for example, if one are willing to risk 5% of their trading account value on a particular trade then they simply purchase that amount of options. So there is a $10,000 trading account and the risk 5% per trade then one would purchase $500 of option premium. If the option is trading for $1 then it will cost $100 per contract and there would be a purchase 5 contracts. 

If the trade moves against us initially there is nothing to do. There is no stop-out level and we simply hold the position until either it expires at $0 out of the money OR it turns around and gets profitable again.

If the trade moves in our direction initially then we manage the trade using our EW guidelines and protect our profits along the way cautiously at which point I will provide guidance and updates. Typically when we get to around 100% profit I will become more cautious as this is typically where we run into a key pivot level and at that point will need to decide based on a number of factors whether to take profits or let things run. 

Those are the simple and basic rules and I set the system up this way for a reason and based it on my many years of observing how the market reacts within our EW and fib pinball system. 

Where I think people are getting confused is when the trade may initially go against us and not see immediate follow-through. This happens a lot and is very common and in fact a large percentage of our trades will start out this way. It does not mean that the trade will not ultimately work out. 

Remember when we are dealing with EW we are dealing in probabilities as well as counts on multiple timeframes. So I may set up a trade using the best-case scenario with the primary count that is looking in a particular direction only to see that cont not follow through initially. There will however still be a valid alternate count that is pointing in the same direction that simply will need a bit more time to work itself out. 

Most of the time I try to give enough time on the options to allow for this. This is why I do not use stops on these setups. Because we have been dealing with very sloppy and corrective wave action over the past several years we have seen this occur quite frequently and again a trade moving against us initially is not uncommon. I am not going to be able to layout every single alternate count that is possible as I have to choose what I view as the most likely. As the market moves then this will change and I will adapt and update the charts as I see them. But as far as the trade is concerned it really does not affect anything because the risk is defined ahead of time and if the trade moves against me again it simply does not matter as there is no stop.

To address the current IWM trade which seems to have raised some questions. 

The current IWM trade was set up as an Ending Diagonal reversal trade. My primary count was (and still is) that we have topped at the 3/8 high. I am looking for a move back to the origination point of the ED at the 187 level by April 1st which is about 61.8% of the time that the ED took to form. That was and is the setup. That setup remains valid as long as the high at 210.47 is not broken. Even if the high is broken we still could see a sharp reversal but the odds that it occurs before 4/1 are quite low. 

There have been a number of different possible paths that I have been watching down off of that 3/8 high. With today's move up those more immediate breakdown paths have been invalidated. It does not however invalidate the larger setup and the setup that the trade was based on. What I am now watching as noted in the room is the potential for this to be forming a leading diagonal down off of the high as part of a wave i of a larger wave 1. Again as long as we hold under the 210.47 high this count remains valid. 

If we break over the 210.47 level then we likely are following the purple count and we will see another higher high. It would make it less likely that we the trade established on Monday will work out but because it is still a larger ED it is not out of the question, just less likely. In either case, it doesn't matter because there are no stops. The stop is the option premium paid.

I hope this answers some questions and please feel free to ask follow-up questions in this thread and I will do my best to answer. 

Michael Golembesky is a senior analyst at ElliottWaveTrader covering US Indices, the US Dollar, and the VIX. He contributes frequently to Avi's Market Alerts service at EWT while also hosting his own VIX Trading service.