The perfect trade entry
Every trader needs a trade entry system. In chapter 3 we covered the first fundamental step of trading, that is, to choose the market in which you want to trade. But, within each market, there is a plethora of trading opportunities to choose from – I call this the universe of securities. So how do you choose from this vast universe? Simple. Predefine your entry rules.
Trade entry rules are a stringent set of conditions that you develop, document and then apply, to decide when you are going to enter a trade. It doesn’t matter what securities you’re trading, you just need a consistent method of entry. Like sifting through a bucket of sand trying to find pieces of gold, the same approach is used to reduce your universe of securities to a shortlist of those that meet your criteria.
Developing your trade entry rules
As in all aspects of trading, there are many theories on trade entry and how to exit trades. I believe the best way to approach entries should be simple, direct and leave nothing to human judgement.
This is contrary to the philosophy of many traders who buy stocks based on media reports, ‘expert’ opinion, rumours and/or gut feel. The good news is that by acting contrarily, you will do what most traders never do… make a profit.
Reinventing the wheel
I spent a lot of time in chapter 3 telling you why you shouldn’t copycat someone else’s system, but that’s not to say you can’t take elements of a proven trading plan and stitch them together into something that will suit your personality.
Let’s revisit the example of Richard Dennis and his Turtles. Dennis’ protégés were successful because they were under his direction at all times. Every trade was heavily scrutinised and made according to his strict rules. The students had to follow these rules or be dropped from the project.
The fear of loss forced the traders to follow the system no matter what. In the real world, most people would not have the discipline to do this. And nor should they; it wasn’t designed for them.
Furthermore, the Turtles were trading with someone else’s money. When it’s your own money on the table, you need to be completely comfortable with the decisions you make, and you can’t do that unless your system suits your personality.
Dennis’ students went on to become successful traders in their own right because they learnt discipline from their mentor, not because they continued to trade his system out of the box. They adapted it to suit themselves. And that’s what you should do.
Think of it this way: how many people do you know who have stayed in a job or field of work just because it’s what they’re used to? They may not love it, but they persist just the same.Maybe you’re one of those people. But, while these people might be able to do that job with their eyes closed, they will never excel at it if they’re not passionate about it. Their heart needs to be in it.
Trading is the same. If you’re not 100% behind your trading system, chances are you won’t be able to stick to it, and if you can’t stick to your system, you will never reap the benefits you are hoping for.
Keeping trade entry rules in perspective
Most traders believe the key to success is being able to pick the bottom of the market. This is why 99% of traders spend most of their time fidgeting with the entry; they are looking for that elusive secret, That one setup that will ensure ongoing success.
But let me tell you from experience – that setup rule doesn’t exist. And, in actual fact, it’s not that important. Spending countless hours optimising your trade entry rules, trying to find that ‘perfect’ indicator, can actually do more harm than good. Over optimisation based on historical data actually decreases the profitability of your trading system when trading in real-time. Typically, the more you optimise, the less robust your system tends to be.
Remember Tharp’s chart? (refer to chapter 2). He said that the trading system, which includes your trade entry rules, accounts for only 10% of what it takes to be a successful trader. That means, there is another 90% of ‘stuff’ you should be concentrating on, such as money management (discussed in chapter 6).
Amazingly, a system can have a very random entry signal and still be profitable as long as money management is in place. Take the following real-life example from Tharp.
Tom Basso designed a simple, random-entry trading system … We determined the volatility of the market by a 10-day exponential moving average of the average true range. Our initial stop was three times that volatility reading.
Once entry occurred by a coin flip, the same three-times-volatility stop was trailed from the close. However, the stop could only move in our favor. Thus, the stop moved closer whenever the markets moved in our favor or whenever volatility shrank. We also used a 1% risk model for our position-sizing system…
We ran it on 10 markets. And it was always, in each market, either long or short depending upon a coin flip… It made money 100% of the time when a simple 1% risk money management system was added… The system had a [trade success] reliability of 38%, which is about average for a trend-following system.
Although a little convoluted in its explanation, this example illustrates that an entry strategy as simple as a coin toss can turn solid profits.Most traders spin their wheels trying to get in at the ‘best’ price, even though this is not where the money is made.
So what’s the take-home rule here? It is easier to copycat your way to success than to try to re-invent the wheel. According to Anthony Robbins, the way to become as healthy as possible is to find the healthiest person you know, ask them how they do it and copy them.
Similarly, the way to select your trade entry rules is to find the best, proven entry system you can for your selected market and model your entry on that system..Sure, you can waste months and spend thousands of dollars testing different methods, but why put yourself through that? Would you rather be a wealthy copycat or a broke trailblazer?
Trading is one of the few industries where people actively share their methods. In other areas of business, people tend to keep their success secrets to themselves; in trading, there are innumerable proven systems and models out there that you can access. Admittedly, you have to pay for most of them, but they are readily available.
So now you have two choices: you can design your own trade entry rules (which includes appropriate back testing) or you can apply a ready-made entry system, confident that someone else has done all the hard work for you.
The better choice seems obvious to me, but I’m not here to make your decisions for you. I’m here to pass on as much information as I can and help set you on a course that will suit your situation.
Going it alone
If you have decided to give it a go yourself, here are a few good rules of thumb to follow. Your trade entry rules should address each of the following:
Let’s look at these in more detail.
The cornerstone of technical analysis is the trend. Remember ‘the trend is your friend’ and you always want to trade with it, not against it. I believe this to be the most critical component of any trade entry system. You need a way to measure the trend.
There are many ways to identify trends, and as with most things in trading, there’s more than one way to skin a cat. The key is to have a method in place.One of my preferred methods for identifying trending securities is to find securities trading at their recent highs.That is to say, the highest high price must have been achieved in the past x number of days (where x is the variable depending on the timeframe you are trading). The longer the timeframe, typically the higher the variable.
If I were to trade a medium to longer term approach I might want the highest high price in the past 200 days to have occurred in the past 20 days.I use a charting package called MetaStock (covered in more detail in chapter 8).
Using MetaStock, the formula would look like:
HHVBars(H,200) < 20
Liquidity is an important determinant because you want to be trading securities that you can buy and sell quickly and without moving the market.You never want to be caught in a position where you want out but there’s no one to buy.
With liquid instruments, such as the forex market that trades billions of dollars each day, trades are happening constantly, so your activity alone will not move the market. In short, avoid illiquid securities.
Depending on the size of your float, you might want the average daily trade volume to be greater than $400,000. This could be achieved by requiring that:
The 21-day average of volume multiplied by the closing price be greater than $400,000.
Using MetaStock the formula would look like:
Mov(v,21,s)*C > 400000
Volatility is simply a measurement of how much a security moves. Not whether it goes up or down, just how much it fluctuates.It is important to trade securities that move enough for you to make a profit. Of course you don’t want securities that are so volatile you can’t get to sleep at night.
On the other hand, you don’t want something that moves at such a snail’s pace that it is not delivering the returns you are after.One of my favourite ways to identify volatility is using the ATR method, which indicates how much a security will move, on average, over a certain period.
Here’s how I might use this method. A $10 security might have moved fifty cents per day on average over the past 21 days. I can simply divide this value by the price of the security to calculate the average percentage movement of a security over the past 21 days. With this value, I can stipulate a minimum and maximum volatility value.
If I were a reasonably conservative trader I might want a security to trade between a band of 1.5–6%. That is to say, I want the ATR divided by the average closing price, over the past 21 days, to be greater than 1.5% and less than 6%.
Using MetaStock, the formula would look like:
ATR(21)/Mov(C,21,S)*100 > 1.5 and
ATR(21)/Mov(C,21,S)*100 < 6
Tip: A great place to start when researching your entry rules is to print out all the trading candidates you would have liked to have traded in the past. Next, mark on the charts themselves where you would have ideally liked to have entered. Finally, look for common characteristics among those entry points – these similarities can form the basis of your entry rules.
Adapting a proven system
If you’ve decided adapting a ready-made and tested system is best – I’ve done the hard work for you. I have hand-picked the best systems for your chosen market.These courses will not only educate you about the market you choose but they also provide you with the exact trade entry rules you need to include in your trading plan.
Simply follow the link to your selected market.
- Stocks – www.ultimate-trading-systems.com/stocks
- Options – www.ultimate-trading-systems.com/options
- Futures/commodities – www.ultimate-trading-systems.com/futures
- Forex – www.ultimate-trading-systems.com/forex
Documenting your entry
Finally, as with everything we do, it’s important to document your new trade entry rules. As I’ve said, a good set of entry rules are simple, direct and leave no room for human judgement.Take the trade entry rules discovered through your own research or from your selected program and write out exactly how you will enter a position.This simple act of documentation puts you among the top 10% of traders.
- If you have decided to develop your own system from scratch, plan your entry criteria making sure to do an appropriate amount of back testing – documenting everything.
- If you’re looking for a ready-made entry system to get you started, get yourself the system that corresponds to the market you have decided to trade in:
Stocks – www.ultimate-trading-systems.com/stocks
Options – www.ultimate-trading-systems.com/options
Futures/commodities – www.ultimate-trading-systems.com/futures
Forex – www.ultimate-trading-systems.com/forex
Still not sure what to trade? Purchase Triple Your Trading Profits – This course shows you how to select a market that’s right for you. www.ultimate-trading-systems.com/tytp