Some believe that in equity trading “the entry is 85% of a trade’s success.” Given the amount of attention most traders give entries, that would appear to be a common belief. There is no question that sound entry logic and precision timing are key to profitable trading, but what you do after the trade also
is critical.
With all due respect to Oliver Velez and Greg Capra, good entries get you in the game, but managing the trade intelligently is what helps you win the game. A lack of trade management planning is the biggest downfall for aspiring traders. It’s not uncommon to enter a trade and then sit on your hands, wondering what to do next. Even worse is making a great entry then coming to the realization you’re lost, and by the time you come up with a plan, your profits have evaporated.
A lack of trade management skills also opens you up to inconsistencies that can plague your trading over time. For example, if you just came off a trade where an otherwise good entry was immediately stopped out just before the market resumed in your direction, you could enter your next trade psychologically biased to widen your stops only to exceed your typical risk parameters on a subsequent loss. Often, when traders lack a trade management plan and miss a move, they overcompensate on the next trade, which results in setting themselves up for disaster by staying in too long.
You need a plan for managing your trades. With a good plan comes confidence, and confidence can be one of the most important elements for long-term success. Without confidence in your methods and your ability to execute them, you’ll never reach your fullest potential as a stock trader.
THE HUMAN FACTOR
A complete approach takes into account entries, exits and trade management, and also the human factor. If confidence is one of a trader’s most important attributes, then the methods a trader uses should, by design, feed that confidence.
Like your trade, equity needs to grow as a result of productive implementation of a sound method, and so does your confidence.
One key to doing this is to find techniques that offer flexibility and fit your own personality, risk tolerance and reward goals. As an added bonus, strategies that best fit your personality will require the least amount of self-discipline to implement. You’ll also be less likely to succumb to emotional impulses that pull you in another direction.
Master traders know that steady profits are the mother’s milk of growing trade equity, while occasional home run trades are what Seabiscuit was to horse racing. Slow and steady profits are as boring as watching paint dry, but they are the building blocks to profits and confidence. Nothing makes a professional feel more satisfaction than to look back at a given trading day, week, month, quarter or year and see a steady flow of winners. An occasional loss doesn’t faze a trader who has experienced a succession of winners because with each successive winning trade, confidence grows to the point where an occasional mistake isn’t financially or emotionally damaging.
Mix that consistency with the occasional home run trade that makes triple-digit returns, or more, and you have the recipe for career-long success.
TORTOISE AND THE HARE
The tortoise was slow, visibly over-matched physically, and prodding but religiously went forward toward his goal. He had the internal attributes of consistency and perseverance, which made up for what he lacked in athletic grace and speed.
The hare, however, was the ultimate symbol of speed. Unfortunately, what no one could see was that he had no self-discipline, focus, sense of delayed gratification or drive. Instead, he wanted to play and be reckless, demonstrating arrogance and assuming he would win against a physically over-matched opponent.
As we all know, the hare’s attitude cost him the race, and he had no one to blame but himself. Like a trader following a foolish trade, the hare may well have had a crisis of confidence and never recovered his racing form.
Your goal, as a trader, should be to take the strengths of both the tortoise and the hare and design a method of trade management. The simplest, and one of the most effective, is to use a system of profit taking and trailing stops combined with simple moving averages (SMA).
BETTER THAN AVERAGE
Most periods of contracted price action will be followed by periods of expansion. SMAs can help measure the strength of the expansion by the relationship to each other, while also serving as guideposts to profit taking within the framework of sound trade management. For example, consider Baidu Inc. (Chinese language Internet search provider, symbol BIDU), using the 10-day SMA and 20-day SMA when price expands from an area of contraction into a bullish move.
The general market was still in a downtrend, but BIDU was showing a lot of strength and had been in a contracted price range for more than two months since December 2008. Notice the 10-day and 20-day SMAs and how they are flat, indicating no trend is present (see “Sideways action,” above).
In the beginning of February, the 10-day SMA crosses over the 20-day, alerting you to a possible buy set-up. Then, on Feb. 24, 2009, after showing bullish signals within the price range, you see a large price range bar higher than the previous day’s volume break out through the upper trendline to the upside of the trading range. The price bar is the largest price bar of the 20 previous days, plus it closes in the upper third of its range, which is a strong trigger.
If you happened to miss that breakout, there was good news a few days later.
After the initial thrust to the upside, BIDU pulled back to minor resistance for a possible pullback setup. Notice how the two moving averages are beginning to shape up.
On March 2, 2009, price pulls back to the 10-day SMA without violating the 20-day. If it did, then the setup would have been void and you would have had to step aside. This was followed by an inside trading day on March 3, 2009.
On March 4, 2009, you get your signal to pull the trigger and you enter on the open at $152 as price gaps completely outside the previous day’s price range. Now that you’ve entered, you’re going to risk no more than 5% off your entry while taking half your position out at two times your risk. This will give you a quick reliable gain. This is the tortoise phase of this trade management strategy.
On March 11, 2009, your first target is hit at $168 and you gain $16 on the first half of your position (see “Off and running”). Now you let BIDU reveal if it’s a hare or tortoise on the second half of your position while using the 20-day SMA as your trailing stop. The following day, on March 12, 2009, the general market confirms a bottom, and BIDU takes off while leading the rest of the market during one of the greatest short-term bull runs since the stock market crash of 1929.
Finally, on June 22, 2009, BIDU pulls back to the 20-day SMA and your trailing stop was hit at $274. The last half of your position gained $124, an 80% gain inside of three and half months. That works out to a 274% annualized gain.
CLOSING BELL
While it seems like common sense to scale out at the appropriate levels, the reality is that most traders don’t because of the overemphasis on entries. This is understandable but obviously becomes a glaring blind spot once an entry is already made with no plan afterwards.
The good news is that gaining a solid understanding of how to make consistent small gains (the tortoise phase), while putting yourself in the position to capture runaway moves (the hare phase) and make spectacular gains not only builds your profits but builds the unshakable confidence of a master trader. Whatever approach you use, though, remember to keep in mind the importance of building it around the cornerstone of consistent gains and confidence by making steady profits in your trading approach.
By building a strategy of trade management that results in a string of consistent gains, you will stay profitable and keep yourself in play for occasional runaway moves.
Billy Williams is a 20-year veteran trader specializing in momentum trading in both stocks and options. Read his market commentary on www.StockOptionSystem.com
