Picking The Right Entry
Often times the emails I received have common themes, for example that I write about one particular topic and sometimes I will get dozens of comments or requests asking me to write about completely unrelated topics. On this particular occasion, the great majority were requests for additional entry methods.
Specifically, I was asked several times to provide entries that provide 3 specific traits: high probability of working out in your favor, small stop loss levels to minimize risk and lastly, tremendous profit potential.
Unfortunately, after reviewing the emails, I quickly realized that before writing the two previous posts, I should have written a more general one outlining different entry profiles. The reason why I think it's important to understand entry profiles is because it will make you understand the underlying predisposition of market behavior as it relates to your particular entry style.
To phrase this differently, each entry style has inherit characteristics that appear during a particular trade set up. Once you understand that each entry style has it's own unique advantage and disadvantage, you will be better aware and prepared to realistically assess the value of each new entry method you come across.
To provide a brief example, if you knew that scalping methods are commonly associated with small profits, you would probably avoid scalping if your major concern is large profit targets or if your major interest is high probability entry strategies, then short term breakout entries would probably be on the bottom of your list.
This is precisely the reason why I get so frustrated by trading advertisements that promise entry methods that provide high probability, low risk and large profit potential all in one. The reality of the situation is markets go up, down and sideways and there are only a few different ways to enter markets and each way has its own positive and negative profile associated with it.
Most entries fall into one of these three areas: High risk, Medium risk and Low risk. While initially you may ask yourself why would anyone want to trade anything but a low risk entry method? The answer is very simple. The risk associated with the entry is typically indicative of the profit potential or the reward of the trade. Hence, high risk entries typically have the largest profit potential, medium risk strategies have medium profit potential and low risk entries are usually associated with the lowest profit potential of the three entry methods.
To put this into context I would consider breakout or trend following entries as having the highest risk and highest profit potential, reversal or retracement entries as having medium risk and average profit potential and scalping methods having the lowest risk and lowest profit potential. Coincidentally, high profit potential trades typically have low percentage of profitability, medium or average profit potential trades have average win to loss ratio and scalp style trades or low risk trades have high percentage of winners to losers ratio.
The reason why I wanted to bring up the three categories is because I think it's important for you to know as soon as possible what type of risk and reward profile is inherent in the type of entry you use. Meaning, don't expect to find a breakout trading strategy that has an ultra conservative stop loss level or a scalping strategy that promises big profit potential, it's just not very likely to happen.
The same principal applies to scalp style trading styles. Typically, day traders scalp during quiet time periods when markets are not unusually volatile. This allows traders to take quick profits without the risk of volatility creating additional risk to the position.
Traders who initiate scalp style trades during periods of high volatility, increase the risk of positions going against them substantially more because there is less control when liquidating the position and the odds of the fill being worse than expected is dramatically increased, putting the trader in a position where there is a risk of having one losing trade wipe out profits from several successful trades.
If you think about this logically, most breakouts are accompanied by high volatility and increase in volume, when traders use tight stop loss levels in this market environment, the odds are very high that they will be stopped out of a trade. Therefore, breakouts typically are inherently volatile strategies that have a high risk and a high reward profile.
Another good example is when markets are reversing after a long trending move in one particular direction, there is usually a consolidation in volatility, mostly because majority of the time, immediately prior to a reversal, markets tend to peak out and expand all the volatility and range expansion on the last leg of the remaining trend. This doesn't occur each and every time but it occurs the majority of the time, especially after a strong trend in the preceding direction has just ended.
Since reversals happen when markets consolidate, there is less volatility and in turn less risk than when breakout occur, therefore reversals tend to be less volatile and therefore more risk adverse than breakout entry methods.
Similarly, market retracement also occurs when the market backs away from the direction of the prevailing trend and begins to consolidate and slowly change direction, even though only temporarily. This short pullback away from the main trend is typically accompanied by contraction in volatility, causing less risk and in turn less profit potential as a result.
I can provide additional examples, but by now I think you are starting to see my reasoning for writing about this topic. My main point is to get you to understand that each different entry method has different characteristics associated with it and once you realize and more importantly internalize this, you will begin to gain insight into which entry method fits your psychological makeup, comfort level and risk tolerance.
Only when you can internalize and truly understand the positive aspects and more importantly the negative aspects of your trading strategy (every strategy has both) will you completely trust and follow your trading rules during a losing period. The biggest reason why traders abandon their trading strategy is lack of trust in their trading method during draw downs (losing periods.)
The second reason why I want to bring awareness to trade entry profiling is because most traders who are just starting out need a positive trading environment, this is crucial so that your neutral attitude towards the markets does not become altered by fear and anxiety which occurs all too often when traders are just starting out and experience a losing period in the beginning of their career.
Many years ago I coached a trader who was just starting out and wanted to learn to scalp the E-mini SP market during the trading day. After teaching the trader a few basic scalping strategies and watching him execute trades I noticed that the trader was great at cutting losers but had a difficult time following several indicators throughout the trading session.
I discussed extending the time frame and adjusting the exit parameters and in the end, the trader ended up with a strategy that felt very natural and comfortable. As a result he remained loyal to this particular strategy and made very few changes throughout the years.
The point of sharing this story is to demonstrate the importance of matching the strategy to your personality. When you know the particular upside and downside and the natural propensity of your entry, you will be better prepared and experience less stress and anxiety in your trading. This will build confidence and lead to a positive trading experience in the long run.
Good luck in your trading