One of trading’s most sought-after goals is divining an effective entry strategy. This also happens to be one of the most contentious areas of debate among traders. This is because the range of entry methodology is vast and, without exception, there are die-hard followers of different approaches. Most systems seek to catch breakouts because they lead to large moves in short periods of time.
While most professionals will tell you that risk management, cutting losses and letting profits run are the most important elements of systematic trading, it is self evident that effective entries are a key factor in increased overall performance, especially when they capture breakouts as they occur.
Many techniques use a one-size-fits-all approach to the market. But markets are dynamic, constantly in a state of flux, and tailoring your entries to capture the current dynamic is key. The reason for this flexible approach is that markets comprise buyers and sellers. Depending on who has control at the time of a potential entry, prices will move up, down or stay range-bound. Often, when one side takes control the other capitulates, which leads to explosive moves that can be exploited, if you know what to look for.
Follow your plan
As Mike Tyson once said on boxing, "Everybody’s got a plan until they get hit." Traders face the same scenario. The problem you face when pulling the trigger is that price action at any given moment may not necessarily present a step-by-step, cookie-cutter approach to a particular entry approach. You can have a great method and plan of entry, but when the unexpected happens, even the best of plans prove worthless.
If you don’t have a strong set of rules for pulling the trigger at that all-important moment of taking a position, then you run the risk either of getting left behind and watching a trade slip away or taking a gut-wrenching loss.
Worse, poor entries create a crisis of confidence that can be just as devastating as a loss of capital. While both can have negative effects on your mindset, capital can be replaced if your confidence remains high. But all the investment capital in the world does you little good if you are too gun-shy from past losses to keep trading.
In his book, "The Hedge Fund Edge," author and hedge fund manager Mark Boucher conducted a detailed study of the characteristics of runaway moves in stocks and the price patterns that have proven statistical edges that can give you a huge advantage in timing your entries and catching massive moves in the market.
These price patterns were labeled Thrust Breakout, Breakaway Lap and Breakaway Gap.
Price levels & entry signals
When a stock is building up to making an explosive move, these three price patterns occur as price moves into trend expansion. During this period, support/resistance levels are created from modest five- to six-day price corrections before building up enough steam to breakout. It is in these moments — whether on the daily, weekly or monthly time frame — where these patterns form and give you the green light to take a position. As momentum carries the stock higher, you have to understand the individual characteristics of each pattern to benefit from them.
The Thrust Breakout is a move above a resistance level in which the daily price action is two to three times the previous 20-day average and whose volume is higher than the preceding trading day. A thrust bar’s price action also will close in the upper third of its price range on the day it breaks through resistance, signaling an entry point in the stock and letting momentum carry your position higher (see "Unexpected thrust").
In simple terms, this type of price bar is a large-range day that occurs on higher-than-previous day volume where price closes nears its daily high. If you see a price bar like this, then you likely are witnessing a large-range day. If you are witnessing it as it trades up through resistance or below support, then you are spotting a Thrust Breakout.
The next price signal is the Breakaway Lap, which occurs when price moves below support or resistance. In a bullish setup, a Breakaway Lap up occurs when prices make a low that is greater than the close of the previous day, but less than the previous day’s high. During a bearish setup, a Breakaway Lap down occurs when price makes a high that is less than the prior day’s close but greater than the prior day’s low.
On a price chart, you can observe a Breakaway Lap in either direction by the hole it leaves in its price action from the previous day’s daily range to the present price bar where the price signal forms (see "Breaking away").
Depending on whether this pattern forms in either a bullish or bearish context, it indicates a flood of buying and selling that pushes a stock’s price out of the normal trading range from the previous closing price to the current opening price. Because of the extreme supply and demand, volume is not a factor when confirming the entry, but instead the signal is confirmed based on where price is trading —support or resistance — at the time the signal materializes.
The final and most explosive price pattern is the Breakaway Gap. The Breakaway Gap creates a huge space outside the daily price action of the previous trading day’s range and the current trading day at a critical support or resistance price level.
A Breakaway Gap can be either up or down. A gap-up pattern occurs when the low of today is greater than the high of the previous trading day. Likewise, a gap-down pattern develops when today’s high is below the previous day’s low (see "Making a gap").
Although any price chart will show a number of gaps, the defining characteristic of a Breakaway Gap is that it trades either up through resistance or down through support.
Breakaway Gaps are common during earning season when publicly traded companies report earnings that exceed or disappoint expectations, resulting in a large move. Similarly, like the Breakaway Lap, when a gap is formed at these price levels — support or resistance — the stock’s trading volume is not needed to confirm the entry but only by trading through these price levels.
While these price patterns make effective entry signals by themselves, they are more profitable when trading in the direction of a strong trend. In his book, Boucher explains that the way to maximize these entries is by identifying the primary trend currently in place and then waiting for the stock to enter a period of price contraction. The target contraction amount is a trading range that is within 1.62 times the average range of the last 20 days for at least 10 days — or within one day’s range for seven days or longer.
Taking time to master the nuances of these studies and the patterns themselves gives you an advantage in today’s market environment. Begin by studying price charts and labeling the primary trend in place, identifying the price ranges that fall within the guidelines detailed and spotting the entry signals as the price patterns develop.
As with all things, practice breeds excellence. Once you have trained the visual cortex of your mind to identify the points of entry at maximum points of potential, your entries will be more effective, possess greater potential and harbor higher rates of accuracy.
Billy Williams is a 20-year veteran trader specializing in momentum trading of both stocks and options. Read his market commentary at www.StockOptionSystem.com or his newsletter on ETF trading at www.FinanceBanter.com.