Traders use various techniques and methods in order to limit risk in their trades, the most common method is that of stop loss orders in the price domain, which all brokers facilitate and offer to their clients. The problem with stop loss orders is that they are often triggered for no good reason, and as a result traders are forced out of their trades by the market, only to see the market later changing direction again and going in the originally predicted direction. If stop loss orders are too big they might pose too large risk to the trader, and if they are too tight, they will almost certainly be triggered by the market. Wise traders have developed techniques for using stop loss orders in the price domain, and most of the time they are able to cut most of their losses, while still being able to maintain their judgement on market direction, and at least some trades open, through the volatility of the markets. There is however one more method for assessing the market and determining whether or not a newly opened trade is worth keeping. This method uses large stops in the price domain, and also notional stops in the time domain.
The idea behind notional stops in the time domain is rather simple, it is based on the assumption that when it is taking too long for the market to move in the desired direction, somehow the probability of that trade being profitable starts to decrease, and in fact it decreases exponentially as time goes by. This method works very well in the hands of experienced traders trading specific markets, markets that they understand in great depth. As a result, when the market is expected to make a move, but time goes by and nothing really happens, as the market makes a little move in the desired direction but then stalls and stays flat. Traders who use notional stops in the time domain will count minutes, hours or days, depending on their time frame objectives, and they have set time limits. If these time limits are reached and their trade shows too little or no profit, they label that trade as a would be losing one, and they close it. Very often, they are able to close would be losing trades before they show any loss, so in effect they are avoiding 100% of the potential losses, long before the stop loss orders in the price domain could ever be triggered. In a nutshell, this is how notional stops in the time domain work.
Day traders typically use time limits of around 15 to 30 minutes, if the trade in question fails to become profitable within that time limit, they believe that the probability for success has evaporated, and they close the trade. Swing traders on the other hand use various time limits, anything from several hours to one week. Notional stops in the time domain are time limits which are specific to each market, stock indices for example have time limits of 2 to 5 days. Traders would count such a number of days whenever a new signal appears on the daily chart. If the time limit is reached and the market has failed to move, they consider the trade a would be losing one, and they get out of the market immediately, even if the trade is partially profitable.
Getting out of a trade because of the notional stops in the time domain does not mean that the trader expects the market to reverse, the market may reverse slightly, or trade sideways or do all kinds of things where no clear exit price level is known. That is why instead of reversing side, they simply get out of the market and wait for the next opportunity.
The above daily chart shows the Russel 2000 stock index. The first blue arrow indicates what appears to be a valid sell signal, but over the next 5 sessions the market fails to produce any downside and it simply trades in a range. The trader utilizing a time limit of 5 days would label this as a failed sell signal, and they would close their short trade on the fifth day, possibly without incurring any loss at all. The second blue arrow indicates how the market reversed at the 200 day moving average, a trader going long would once again count days, and give the market five days to start rising or else close the long trade. The market in this case has been rallying, so the trader would keep the long trade open.
The probability of a trade going well is known to be related to price action relative to the passage of time, even though nobody has a perfect theory on this, time limits act as notional stops in the time domain, and very often they work well. This might be because when it is taking too long for the market to start moving in the direction that a new signal hints, investors and traders start having second thoughts, and this hesitation causes all this delay. It somehow means that investors are worried about something, especially longer term investors who are looking to stay in a trade much longer than most traders. Most traders trade around the medium term cycle, attempting to catch the ups and down of market price from one week to the next. It is also a fact that markets produce and will always produce false reversal signals and false trend start signals, and they do even more so when volatility is high.
