It Doesn’t Stop At Trade Entries

Posted in: Advanced Trading Strategies, Trading Article

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Many traders are looking for the perfect trading setup thinking the setup and trade entry is the key to success.  To all those people who believe that is the missing variable and once found their path to riches will be shown:  Trade entries are just one element to a successful trading strategy.

There’s certainly a lot more that needs to go into a winning strategy such as:

  • Position sizing
  • Exit strategies
  • Capital management

Some traders will look to always improve their entries to help cut down on the number of losing and that shows that not everyone has a productive view on trading entries.

But you have to start a trade somehow and since trading is a sequential event, the entry is the first part of the sequence.  A poor entry could make everything else you do in the trade a little more difficult

 

Risk Is Not Just A Percentage

When traders hear risk, they look at just how much they can lose on the trade.  Risk can also be the likelihood that your trade will be stopped out.  This is a big concern for those with small trading accounts.

I find it very common in Forex where traders will place their stops “a few pips” around market structure or individual candlesticks.  This is done because these traders need a tight stop to enable a larger position sizing.  While there are trading strategies that take many small losses but have a few large winners, imagine what constant stop loss triggers do to a traders confidence.

Losses add up and when you factor in spread costs or commissions, the amount of money you put up for the trade is actually a little larger than your set risk percentage.

 

Make Price Work Hard To Take Your Stop Loss

So what the risk of taking a loss comes down to in the simplest of terms is this: how hard does the market have to work in order to stop you out and so what are the chances you will be stopped out on any given trade?

There are two ways in which this works.

The first is the level of preceding activity that is present at or close to your entry and this often ties in with the second way which is market structure – where supply and demand have previously been present and therefore could be present again in the future.

Market structure is what I want to concentrate on here as I think it’s a concept that many people reading this understand.

Structural risk is how likely the market is going to be able to stop you out based on where your stop is with respect to levels.  If your stop is above support for a long trade or below resistance for a short trade, the market will have an easier time taking your stop.

 

Using Support or Resistance For Stops

Dax Support Risk2

You can see very clearly that there’s a static level around 8283.0 in this random Dax example. Let’s say that your strategy is giving you a trading signal to go long and that you have a normal stop of around 20-25 ticks (10-12.5 points).

At the maximum of 12.5 points stop, your entry has to be a maximum of 8295.0 to avoid the 8283.0 level.

But then it’s clear that the level isn’t “to the tick”.  You’d probably want to give it at least another 2-3 points and that would take you to 8281.0 and an entry of at worst 8293.5 to avoid the chance of the market retesting what looks to be recently the most important level before actually turning around and moving to target.

Below 81.0, you’re probably going to be wrong as if buyers are still in control, that’s the place you’d want to see them entering again.

 

Measuring the Swings In The Market

I’m not going to discuss trend lines here as they can be very similar to standard static levels just with the fact that they change over time thrown in. What may not be as obvious is the way in which the market normally ebbs and flows as it moves.

Everyone knows that markets more often than not, don’t move from point A to point B in a linear fashion but instead meander their way back and forth until they reach point B.

What the ‘normal’ level of this behavior is will be specific to the instrument in question and the time frame that you’re focused on.

Dax With Zig

On this chart is a swing indicator added to the same Dax chart to try to illustrate this action. You can see that there are some bigger moves between high/low extremes, but there are also many smaller swings present.

If you were to analyze this, you’d see that there’s a general range of how large these swings are before a counter swing happens.

Let’s say for argument’s sake that a standard swing for the Dax is 25-35 points on the time frame we’re looking at. If you have a strategy which goes with the direction of the current move and the amplitude of the current swing is on the upper end of normal (30+ ticks) then there’s a good chance that your trade will endure at least a high level of MAE (maximum adverse excursion) or be stopped out entirely before the market gets to your original target.

How many times have we all seen a good trade stop out before the market moves to target? It’s certainly not entirely avoidable, but if it’s happening on a regular basis then there’s cause to adjust the way you enter your trades.

For those who run back-testing software, this is why it is important to actually take a look at the trades that have been generated to see how they have happened not just what the outcomes were.

In my trading, I use something called “symmetry in corrections” where I measure the length of pullbacks that have occurred without violating the current trend.  Very often you will find corrective declines (or corrective rallies) around the same price differential.  This can be used in placing stop and/or for finding trading entries.

 

Let The Market Dictate

The market moves based on its structure, not yours. So your risk has to be defined not only by the maximum amount you wish to lose but also where you’re likely to be wrong. The reality is that you work in the market’s universe not the other way around.

By taking the time to look at where your entries are relative to market structure and working with it, you are able to mitigate some of the risk associated with trading and improve the quality of your stop outs. You can be wrong where the market is likely to agree that you’re wrong.

Entries are just one step in any strategy but nevertheless, they are important in managing risk.

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