In-depth Analysis

The importance of having entry and exit prices in trading

I have been involved in numerous discussions about the markets in recent weeks and among the question about which way they are heading there have been questions related to what we might call tradecraft.

One question, in particular, struck a chord as it concerned a potential trade idea, that wasn’t triggered.

And questioned whether on that basis the analysis/thinking behind the idea was valid in the first place.?

I was happy that it was.

But it set me thinking about my approach and the discipline of having well-defined entry and exit criteria for each and every trade you do, or indeed don’t do.

Trading is a discipline, getting it right is meant to be hard?

If it wasn’t it would mean free money for all, wouldn’t it?

By and large, that’s not how the world works – though some argue it might do in future. But that’s another story.

The reason I always try to adopt a disciplined approach to trade ideas is to systemise my strategy and remove emotion and shoot from the hip reactions from the trading process.

That doesn’t mean completely ruling out intuition or gut feelings, these can be useful subconscious cues.

But it does mean having a plan, a style or approach to refer to, and utilise, every time you trade.

Quite simply trading is about the endeavour to accumulate capital. Through the process of taking calculated risks and pitting yourself against everyone else in the markets, each time you take a position.

Because in most circumstances for you to be a winner someone else has to be a loser. 

The risks that you take in trading, are to your capital your net worth. Money that you have probably worked hard for  Or if you were fortunate to inherit some capital, money that someone else worked hard to secure, in that legacy.

Either way, what was hard-won should not be lightly dismissed or frittered away.

Now after more than  30 years in the markets, I think I know quite a bit about them.

However, I don’t pretend to know everything about them and I don’t believe that I or anyone else ever will.

That’s because at some level the markets are the distillation of all the hopes, fears and other emotions, of millions of individual participants. Be they traders at large institutions or private investors.

You could even argue that algorithmic and computerised trading, which these days can take place without human intervention, still reflects these emotions, because they have been programmed by human beings.

Before you enter a trade 

When I think about entering a trade I consider what would I need to see to convince me that there is scope for a genuine move in a given direction, and what would persuade me that there is not?

To that end, I like to see price action that creates a trend change or takes out key price points, such as prior period highs or lows.

But reaching and or breaching these levels is not sufficient justification in itself, as far as I am concerned.

Rather I want to see sustained moves, supported by good volume and or other confirmatory signals.

If we don’t get those, then we risk jumping in on what may simply be a false move or a non-event.

Because make no mistake there are people out there who like nothing better than tripping you up and taking your money.

It’s not personal, it’s just business, as they say. The business of trading.

So that’s why I nominate an entry point and often other criteria in a trade idea. For example a  close at or above a specific price point.

I want to give my trade ideas the best chance of success. 

In effect I want the market to tell me what’s happening and where the balance of supply and demand is.

Changes in supply and demand are what drives price action

An excess of one over the other pushes a price in a particular direction until the point that this balance changes and the price resets.

Perhaps that change comes about because of some new information, or a swing in investor sentiment. We may never know why but we must always be alert to the possibility.

When we have even entered a trade, we need to know what our objectives are.

Now, of course,  making money is the answer to that point.

But, how will we make that money? And how much new money will there be, if we are right? And what are we prepared to risk to do that?

None of this should be ever decided on the hoof, however. 

We should be very clear about our objectives well before pulling the trigger on a trade.

Capital preservation and a sensible approach to risk management are the cornerstones of any successful long term trading strategy.

That means having a profit target or targets on each trade and at the same time a predefined stop loss.

The difference between these two price points defines the risk-reward ratio in a trade.

An important rule of thumb the risk should always be of a lower monetary value than the reward and ideally by a multiple. For instance, I look for a risk-reward ratio of at least 2:1.

That is I want a profit to be at least twice the amount of capital I am prepared to risk on a given trade.

Less than this and you are moving into territory that’s akin to tossing a coin.

Speaking of risk, stop losses help to define this key factor and we need to think carefully about their placement.

We want to be stopped out if our idea is demonstrably wrong.

But we don’t want our stop losses to be seen as low hanging fruit by the market either.

Now, this is important:  stop losses can be subject to slippage. That is they may be triggered at the stop price but executed at the next available price.

Which in adversity could be something very different indeed.

There are limited risk or guaranteed stop accounts, but they may lack flexibility in other areas.

So as well as having a stop loss in place we need to make sure our trade is “right-sized” for our account.

After all, you don’t want a single errant position to take down your whole account. This is particularly relevant to those trading on margin.

So think about what your total underlying risk is in any trade versus your overall account size.

Most traders have a standard trade size or unit that they deal in.

Standardising your trade size allows you to manage your risk and allocate your capital far more efficiently, than deciding how much to risk on every trade.

It can also help you to scale into or add to profitable positions, as, when and if they move in your favour and to scale out of a profitable when it’s time to do so.

Trading is about performance and just as in sports improving performance comes from improving your process- usually by making many small adjustments, that when combined can have a big effect on the final outcome.

 

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