Table of contents
This area of trading is often overlooked by many traders. Answering these questions before you start will save you a lot of emotional stress.
When and how do I enter into a trade?
When and how do I exit from a trade?
Your new trading system has just generated a signal saying that you should buy XYZ stock. Your trading journal will also tell you how much you can trade using your position sizing strategy.
What it probably has not told you is the price to open, the stop loss or a take profit level. Many traders fixate on the perfect entry but it is only when you exit that a profit or loss is realised. The exit is equally as important as the entry, if not more so.
How, when and where to enter a trade?
The answer to this question is similar regardless of the type of trader you are. If you are a day trader, swing trader, trend trader you will need to time your entries to maximise your chances of success. The only difference is you will look at a chart using a different time frame.
The general rule for all traders is to determine the overall trend on a wide time frame (maybe daily or weekly). Signals are generated on a narrower time frame (daily, 4 hour). Trade timing is done on a close time frame (30 minute, hourly). This is a good rule for most trading types and multiple time frames should be reviewed to confirm your thought processes.
The following charts show the S&P 500 in 3 different time frames (Weekly, Daily and 1 Hour).
Note: By looking at the chart in an isolated time frame you could come to a completely different conclusion than if you looked at multiple time frames.
We are now looking at the right chart to time our entry but lets not forget the golden rule of trading. Buy low, sell high. Or, sell high, buy back low.
Don’t just dive into the market and put your whole position on at the open. You need to follow the golden rule and enter at an optimum price with good trade timing.
As a technical analyst you have countless indicators to help you determine when prices are high or low. Lets name a few that are useful for this purpose:
- Commodity Channel Index
- Relative Strength Index
- Williams %R
I would suggest you take a look at these indicators to see how radically different they are when you change the time frame. You may just change your mind and cancel the trade. If this happens often then make sure to include it in your trading journal as a step before every trade. It may also indicate that you need to alter your trading strategy slightly to reduce the number of false signals.
In addition to the above indicator you have classic support and resistance levels. These are areas on a chart where the price seems to get stuck.
Combining one or more of the indicators with support and resistance levels will give you an edge over many other traders who have already entered at a whim. This gives you the best chance of buying at a low, or selling at a high.
If your position sizing strategy includes multiple positions due to cost averaging then this needs to be factored in. You do not want one of your positions to open the other side of a support/resistance level.
How, when and where to set a stop loss?
As part of the previous step you have already identified a potential area for your stop loss. This was the support and resistance levels you defined. The following illustration was taken from the S&P 500 on 30/31 July 2020. Each candle represents 10 minutes of trading activity.
Lets say that our trading system signalled a potential short position. We identified the resistance level, shown by the red line. The red arrow highlights the area where we would enter our short position.
Our stop loss would have been set above the resistance level. A stop loss should always be set at a level where it disproves your original reason for entering the trade. In this example it would be just above the resistance line.
You will also notice that the resistance level turns into a support level. Once price bounces off the line it then takes off and the S&P increases by 1% in 30-40 minutes. My original reason for entering the trade is now clearly wrong.
Setting your stop correctly would have saved you the agony of watching the market go against you.
Defining your stop loss before you enter your trade is vital to ensure your position sizing and risk to reward ratio rules are adhered to.
In addition to support and resistance levels you may also want to consider using the following indicators when setting your stop loss level:
- Swing low/high (Donchian channel)
- Fibonnacci retracement levels
- Bollinger Bands
- Average True Range
- Moving Averages
- Parabolic SAR
Alternative methods of stop loss placement will be discussed when we look at money management.
How, when and where to set a profit target?
By this stage you have defined how, when and where you are going to enter a trade. In addition, you have defined how, when and where you are going to place your stop loss.
You have therefore defined the Risk side of the equation.
But how should I set the profit target?
Before we can decide on a target we need to take a step back. When you performed your system testing you will have identified 2 key metrics:
- what percentage of trades were winners
- what the average risk to reward ratio was
Lets use an example again.
Our system testing showed that we produce 40% winners with an average risk to reward ratio of 1.6. All trades had similar position sizes, each risking £100.
Therefore, if we place 10 trades we should expect 6 to lose and 4 to win. The losses will total £600 (6 * £100) and the winners will total £640 (4 * £160). A net profit of £40.
From this we can conclude that a risk to reward ratio of 1.6 is the absolute minimum we can accept for the system to be profitable.
We can now confirm that our profit target must produce a profit of at least 1.6 times our defined risk (stop loss).
Where we exit a trade should be determined using very similar techniques that were used to define our entry and stop loss. We are just looking in the other direction.
You will likely identify your target using one or more of the following technical analysis techniques:
- be placed just inside a support or resistance level
- coincide with overbought/ oversold indicators
- placed on Fibonacci retracement/ extension levels
What we have not discussed is the when. We can not determine a when as the market would not adhere to it anyway.
Defining your entry and exit criteria before you place a trade and trade timing is vital to your long term success as a trader. You need to know how, when and where you enter a trade. Equally as important is how, when and where you exit a trade. If you are unsure how to execute these types of entries and exits the know your order types page will help you identify the correct one to use.
All of these factors affect your position sizing and risk to reward ratios. We will revisit entries and exits when we look at money management techniques in more detail.
The psychology of trading is an area that Trading AtoZ takes seriously. By defining your entry and exit criteria up front you will remove a lot of emotion from your trading. It also makes your trading day much calmer as you have a plan that is easy to follow.
You could place all of your trading orders when the markets are closed so you do not second guess your decisions at the last opportunity. Do not spoil all of your hard work by changing your mind just before you hit the buy or sell button.
Stick to your trading plan as set out in your trading journal.
Emotional traders often make bad decisions. Don’t be one of them. Define your entry and exit criteria and make sure it is documented in your trading journal.