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Entry and Exit Signals

By: , dated April 11th, 2013

The dilemma most traders are aware of is when to enter a position. But there is more. After you enter, you also need to know when and why to exit the position. Both of these decisions can be based on gut reaction (greed and fear dominating), or on a logical assessment of the price for the stock and recognition of the nonemotional reasons for moving.

Just as investors need to set goals for exiting positions based on profit targets or loss bail-out points, traders also need to know when to sell. When you are operating based on one of the several theories of trading, you really are not aware of risk. That awareness only takes hold once real money is placed into a trade. This is why setting very clear entry and exit rules for yourself is essential to trading success.

Key Point

Even if you understand the steps and techniques of trading, you do not truly appreciate risk until you have actual money committed to a position.

One of the confusing patterns you see time and again is a congestion pattern in price. This occurs after a trend has ended and before another trend begins. Congestion can last two or three sessions or for an entire month or more. Prices move sideways without making any clear moves in either direction. Another name for this could be ‘confusion’ because neither buyers nor sellers are in control, and no one can decide which way prices are going to move next.

During periods of congestion, patterns are going to emerge, giving you a clue about trends about to emerge. It often occurs that traders wait out the congestion hoping to spot a strong trend; but by the time the trend is apparent, the opportunity has been lost. This is a dangerous point in the trend. Some movement away from congestion could end up as a failed signal. The danger of making decisions to either enter or exit positions during periods of congestion is in the difficulty of reading when the period is really ending. The solution is to seek out strong signals of a trend, and to not make a move without equally strong confirmation.

It is better to lose an opportunity because of the dangers in trying to read the congestion pattern than to make a decision and end up losing on the trade. If you consider the patterns taking place right before congestion, the confusion makes sense. It is likely to follow a period of very strong trending price action, even including strong or consecutive price gaps and then exhaustion. At this point, when momentum has been used up, neither buyers nor sellers are able to create movement. This is when failed signals may develop. It isn’t so much that the signal is deceptive, but that it lacks the strength to continue in the direction indicated.

Key Point

In periods of congestion, the uncertainty confuses the decision-making process even with signals; you are better off missing an opportunity than risking a loss in these conditions.

Confirmation may come in the form of two or more reversal or entry signals (initiation of a trend of three or more days, an NRD, or a volume spike). Remember, when two or more of these show up together, it is an exceptionally strong indication that prices are about to begin trending. However, today charts are available to everyone with a computer and knowledge about technical analysis is more widespread than ever. This does not necessarily mean that indicators are interpreted accurately; in fact, with the widespread access there is a tendency to oversimplify the meaning of indicators. Trading is not a formula that works every time; you cannot see a signal and act on it with certainty. Rather, the accurate interpretation of technical indicators should improve the frequency of being right, improving your averages rather than creating sure-fire systems for profitability.

Exit profits can be summarized as percentage gain/loss or dollar amounts. These should be realistic and moderate and, most important, once you set your exit standards, you have to follow your own rules. Otherwise, the exercise contains no value.

Traders make some recurring errors that can be avoided as long as you know about them. These are:

  • Trying to make profits on a trade adequate to make up for a loss previously experienced (this increases your risk exposure and usually will not work out profitably).
  • Converting small losses into large losses.
  • Dwelling on a loss or poorly timed trade rather than learning from it and moving on.
  • Setting unrealistic goals, notably excessively high profits, which ensures you will rarely meet those goals.

Key Point

Traders are at risk of making errors in their approach to trades; the solution is to set clear policies and then follow your own rules.

For entry and exit, note the following signals that provide you with the strongest and best action points:

  • In all cases, even a strong indicator should be confirmed. This may be a matter of confirming an NRD with a reversal day or volume spike, or seeing a three-session trend coming out of confirmation, along with an NRD.
  • Look for gapping action or, as they say in London’s Underground subway system, ‘Mind the Gap.’ Gaps are very significant because they imply that buyers (upside gaps) or sellers (downside gaps) are making their move. Gaps are especially meaningful when they occur as part of a breakout above resistance or below support. However, before jumping in, look for confirmation of a new trend; the gap may reverse and fill, retreating to the established trading range, making it a failed signal.
  • Breakouts that hold and continue to move represent a strong signal, assuming confirmation occurs as well by way of gaps, three or more trending sessions, or other strong indicators.
  • You are going to create more profits by getting in at the proper moment, which is right after confirmation but before the crowd acts. If you wait, it will be too late. Traders who lead rather than follow are going to have more profits.
  • The traditional technical signs, like tests of resistance or support, head and shoulders, and triangles, are valuable confirming patterns but are but not as reliable on their own as the swing trade reversal signs (NRDs, volume spikes, and reversal days after short-term trends).

To accurately decide when to enter or exit, you may select from a number of signals and confirmation. However, the ideal indicator is not always going to show up, so an alternative is to look for a percentage of price movement above or below a previous level and use this as the decision point. You decide to buy if the price movement is downward a specific percentage from the high; you sell if the price movement is upward from the low. This percentage swing approach provides you with a framework and discipline that programs your decision point; it is based on the observed tendency for price to go through predictable swings in three to five days.

Key Point

Using the percentage swing method gives you clear signals for timing entry and exit; this helps overcome confusion and uncertainty, even in volatile markets.

The desirability of percentage swing is that entry and exit are automatic, assuming you follow the rules you establish within the swing. The percentage that you select depends on your risk tolerance as a trader, and on different degrees of change for entry and for exit. For example, if you are out of a swing trade and you use percentage swing to reenter, you may set the percentage at 5 percent or 10 percent. If too high, you may never reach the point; if too low, you might enter too soon. For exit, you might have a greater sensitivity to loss, meaning a loss percentage might be lower than a gain percentage.

Percentage swing is a good system, at least to generate your attention. However, it works best as a first step in the decision, which should not be made until a confirming signal develops. It is possible that a percentage will occur, but the other signals have not developed or you even see a contradictory signal (in technical indicators, candlestick formations, or other methods you employ). In those situations, use percentage swing as one among many different signal points you employ as part of your timing strategies.

Key Point

Percentage swing is best used as a generating change, but the movement should be confirmed by other indicators before you act.

In calculating the percentage swing, it is not always necessary to restrict the test to the change within a single trading session. In periods of great volatility between sessions, you may calculate and track a stock’s true range between the previous day’s closing price and the current day’s high price. This encompasses a range well beyond a single session’s opening and closing, and may provide more significant insights in the price movement and the timing of your entry or exit.

True range analysis may absorb the day-to-day gapping behavior that otherwise clouds judgment and makes interpretation difficult. Not all gaps are visible, either, so true range analysis helps to clarify the situation especially when price volatility is high. These day-to-day gaps are not always visible. For example, if yesterday’s price opened at $26 and closed at $23, and today’s price opened at $20 and closed at $24, there was a three-point gap between the two sessions. However, on a candlestick chart the two sessions overlap, so the gap is not as visible as one in which both sessions move in the same direction.

It also helps to see gaps if you combine daily sessions with higher-volume interim charts. For example, you might see frequent gaps on a one-hour chart that do not show up at all in the full-day chart. This does not mean the day’s session is any more volatile than average; it does provide you with insight about trading action during the session rather than the summarized range information for the entire day. In the true range version of a trading range, the high price is either today’s high or yesterday’s close, and the low is either today’s low or yesterday’s close. This system applies in looking backward on daily charts, or in performing the same function on one-hour or even more frequent charts during the day.

Key Point

Gapping behavior may be invisible, not only between sessions but even within a single session; combining daily charts with higher-frequency charts like one-hour or 20-minute charts helps spot volatility within the session.

Regardless of the duration of your sessions, it is important to understand that gapping behavior affects the conclusions you draw. For example, in a percentage swing, do you use today’s opening price as your point of comparison? Or do you use yesterday’s closing price? If these have gapped overnight, the analysis could be rendered inaccurate if you limit it to the current session only.

The real key to ensuring your analysis of price movement is accurate interpretation of charts. Charting Tools and Interpretation explores charting and the many tools you can find in single-session or multiple-session trends.

"Adapted from Getting Started in Stock Investing and Trading.
Copyright 2011 by Michael C. Thomsett. All rights reserved. John Wiley & Sons, Inc."
Content provided here under exclusive license

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  2. Swing Trading
  3. Entry and Exit Signals

Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2014. Content published with author's permission.

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