Adrian Reid discusses what to do when your trading system signals a buy but the stock gaps up before you can enter. Rather than skip the trade based on emotion, test a rule change first, like using a limit order or setting an acceptable opening range, then backtest it before you trade.
If you get a signal to buy a stock today and tomorrow morning before you buy it, it gaps up a significant amount, should you skip that trade or should you take it?
What do you think? If you get a signal, the stock closes at $10 and you get a signal to buy next bar on open and the next bar opens at 11, should you be buying at 11? Yes. If you have a signal that says It closes at $10. Buy on limit $10.10 tomorrow. Should you be buying at $11? The key is what is the system actually doing? We're not looking at that going, oh, that's gapped up too far. I don't want to trade that. That's an obvious emotional reaction. However, you could take that reaction, which is like, oh no, I don't want to do that. That's gapped up too far, which is a perfectly reasonable observation. And I guarantee I would feel that way if the signal bar was 10 and it opened at 11. It's like, oh, that's a big jump. Okay, I'll just kind of grit my teeth and I'll buy it. Like, you don't feel good about these things. If I didn't feel good about it, I can then take that observation and turn it into a test. And I can say, all right, maybe I should change that to a limit order. So I only buy if it opens a certain amount up, but no more. If it opens further up and doesn't come back during the day, I won't get in.
You can test that. So my key message is if you've got a system, then you need to follow the system. But if something comes up in the system that you don't like, like a trade that has a big gap up and you see that gap and you have an emotional reaction to it, then you need to test a modification to the system rather than taking action on that emotional response. So the gap up is the stimulus that created the emotional response, but it's also the stimulus for you to test that as a rule. So put a rule in that says only enter if the price opens a certain amount up the next day. But if it's a big gap, skip the trade. Test the system with and without that rule and see whether it actually makes a difference. Chances are, if you're having an emotional reaction to something in your trading system, when you test it, you're going to find out that it's going to make the system worse if you add that extra rule. But that doesn't always happen. Sometimes you find a rule that really helps. So if you want more videos like this to learn about systematic stock trading, then make sure you subscribe to the Enlightened Stock Trading channel and give this video a like so you don't miss the next one.
