Understanding the Extreme Point Rule
The Extreme Point Rule is a crucial component to understand in the world of trading. This method is often used in trading strategies, particularly with the financial instrument known as a 'stop order'. It is part of the Wells Wilder's Directional Movement System that plays an important role in determining when to enter and exit a trade.
Application of the Extreme Point Rule
When a trader places a stop order, they are instructing their broker to buy or sell a stock when it reaches a particular price. The Extreme Point Rule is then employed to help determine the optimal point to set the stop order. It works by setting the extreme point during the time of entry into the trade as the stop-loss level. The extreme point is the highest high or the lowest low price during the day of a "plus directional movement" or a "minus directional movement" respectively.
Significance of the Extreme Point Rule
This rule offers traders a particularly advantageous tool for managing their risk. By setting the Extreme Point Rule at the exact moment of entry, traders can protect themselves from potential losses. This carries significant importance when trading in volatile markets, where price swings can often exceed expectations.
Practical Example of Extreme Point Rule
Let's say a trader enters a buy position on a stock whose price is showing a 'plus directional movement'. The highest price of that day is recorded by the Extreme Point Rule and set as the stop-loss level. This means, should the stock's price dip below that level, the position will be automatically closed, protecting the trader from further losses.
In Conclusion
Understanding the Extreme Point Rule can provide a significant edge for traders looking to manage their risk effectively. In a world where profits and losses can happen in an instant, having a method to lock in gains or cut losses at the best moment is what separates the successful traders from the rest.
