I’ve always tried to communicate the entry strategy behind the trades and set ups I post here. So in the interest of that – and because I have not done this in a while – let’s break down how I consider entries, Step by Step. Here are the broad strokes…and I will follow up this post with more detail and charts in my next update.
The first step of any entry is to ascertain the direction of the market. I call this market stages or phases or cycles. The correct terminology is stages or phases but I care less about terminology and more about meaning. The market can either trend up, trend down or move sideways. Determining which it is doing on the daily and also on the time frame you are setting up for a trade is always the first step.
The next step is to determine if price action is in an actionable price area. What’s the clarity of the market trend? Where is (if any) the momentum? Some price areas on a chart are best left alone until the market sentiment, momentum, and trend are clear. Knowing when to leave the keyboard and mouse alone is more important than ever in an age of lightning fast executions and tick by tick price updates.
If you’ve made it to the third step that means that the market stage has been identified on the time frame you are trading, you are clear about the prevailing trend of the market, and that price is in an actionable area. Now it the time to focus on sentiment, momentum, and trend. Depending upon the market stage you could be waiting on a trend correction, trend continuation, trend reversal, momentum or exhaustion. The first three considerations are of course applicable to when the market is moving in an uptrend or downtrend. The last two are considered when the market is moving sideways within a range.
This third step is when you begin to consider the entry level, Point of Validity*, and the potential for follow-through. I think a lot of traders skip the latter part of the this discussion: follow-through. A great entry with too many obstacles in it’s way is really not such a great entry. In order to realize a profit, prices must be able to move in the direction of the current momentum and/or trend. Are there levels in the way? If so this could effect your risk to reward ration and make the trade more expensive/risky that the it’s worth. Even if you’ve made it this far, if the risk of entering the trade is not at least equal to the potential reward, the trade can’t be taken.
*Point of Validity is the term I use to determine where the entry is no longer valid. It’s not just a stop-loss but a consideration of where I’m wrong…NOT based on dollars or a percentage but based upon why I thought the trade was valid in the first place.
In the coming posts I will examine how to accomplish each of these steps with a number of charting tools both discretionary and automated.