The Art of Entering a Trade
Know when to fold 'em before you buy
Through an entrepreneur's network I belong to, I met a fellow who is a relatively new investor. He's interested in learning more about the market in general, and more about technical analysis in particular. I was diving back into my archives to dig out a few things and ran across this article I wrote c. 2001 for the old Biotech Research web site. I sent it to a couple of traders I know who encouraged me to publish it here as they saw it as still relevant. I hope you find it useful.
This is the third most important thing an active independent investor must know. The first is capital preservation and the second is how to exit a position. If you don't understand those tasks, then entering a trade properly is the least of your worries.
Setting rules for entering positions is extremely important. Good rules can lessen the chance you are buying into an emerging downtrend ("catching a falling knife") or chasing a stock to levels it simply cannot support in the short term. This article covers some strategies I've found helpful. As you gain trading experience, you'll develop personal rules which take into consideration your own trading style and willingness to take on risk.
Entering the stock everyone wants
There are millions of people around the world sitting at computer screens just like you are right now. Most have an online trading accounts or are one speed dial button away from a traditional broker. It is increasingly likely they are listening to the same news sources. So, when some famous analyst issues a table-thumping buy opinion on a stock, you are pretty much guaranteed to have a crowd wanting to buy the next morning. This likely means there will be very volatile price action and almost a certainty of a gap up in the stock.
The trick for entering a stock is to make sure you don't step in front of a freight train going the other direction. By letting fly with a market order -- or even a limit order -- first thing in the morning, you are gambling the stock will go in your direction. When you throw in an order in at the open in this fashion, you remove any chance of receiving feedback from the opening price action.
And that's what you must ultimately learn to read: the opening price action. When a stock has a lot of "at open" activity, most streaming real time quote systems will show a cacophony of gyrating bid and ask numbers. The last trade number falls outside the bid and ask spread as often as it falls inside. To a smart investor, the dance of those numbers is very instructive. Trades outside the stated spread and to the upside will generally indicate the stock will continue to go higher. Trades outside the stated spread and to the down side or evenly split between downside and upside typically mean the stock will retreat.
What increases the chance for a successful trade, though, is simply waiting until some significant number of consecutive trades fall between the stated bid and ask. The bid and ask can be moving while this is happening, but the last trades need to always be within the parameters of the spread. This is an indication any order backlog has been satisfied and the market action is calming down. A much clearer picture of the stock direction will begin to unfold.
Take notice of which way the bid and ask are moving. Are there more upticks than downticks? If so, the direction of the stock will likely remain upward at least in the shorter term. If the stock gaps up and you see a lot of downticks at this point, you can usually be certain that all those who bought in the rush are going to lose some money.
Take further notice of where the last trades fall within the bid and ask. Are most of the trades at the ask or at least closer to the ask than the bid? If so, things are looking bullish. If most of the trades are at or near the bid then you're likely looking at a bearish sentiment.
So how long does this process take? Sometimes you glance at the clock and realize you've been staring at this dance for 15 minutes or more. Other times you can see the pattern within 5 minutes. You're not on a timer here, you're watching for patterns to resolve themselves. It's trite, but hasty trades are usually losing trades.
Many investors worry too much about a stock running away from them. There are thousands of stocks. If it runs away, let it go. Most of the time you'll get a buying opportunity during the day anyway. For every stock you chase that turns out to be a winner, experience shows you'll have three that go the other way. If you're really obsessed about a stock running away, place half your money in early and the last half of the position after you wait for the trend to develop. You'll cut any losses this way while taking at least partial advantage of any torrid runs.
This is a guide designed to give someone who hasn't thought about this aspect of investing some context. It is important for you to develop a method of your own. When you're listening to news and hear something that will move a stock at the open, put the stock up on your ticker and make a paper note of where you'd enter. See how often you're right.
To sum up, be patient and wait until a level and identifiable trend emerges. Take into account all three items (general pattern in opening moments, uptick/downtick direction just after it settles, where trades fall within the settled bid/ask spread) and trade accordingly.
Avoiding the "falling knife"
The worst feeling in the entire world is to watch a stock you just entered immediately turn and run the wrong direction. Not only are you losing money, but your ego is being bruised. Stops limit the money loss, but the psychological wound takes a while longer. Too many of these occurrences and you begin to doubt your prowess as a stock picker!
Once again, patience is the operating word. Not every position you enter will be as crowded as the type we describe above. More often than not, you have a few other traders to keep you company in the morning but not enough to make things difficult. Your goal at these times is to make sure those other folks are also trading in your direction.
Once again, watch the ticker. Many times I've entered positions where the stock is dropping in the morning. Often times, the stock rocketed the day before and people are taking profits. Whatever the reason, it is by no means a rare occurrence. Some of our most successful trades have been on stocks that opened lower.
The trick is to wait until the stock stabilizes. If the stock immediately drops on the open, you want to see some consecutive upticks before entering a long position (note: reverse all this for a short position). At least one of the upticks must have some staying power to it -- in other words there has to be a fair amount of trading activity at the upticked spread. Also watch the size of the bid. If the uptick only shows a bid size of 1, wait until you see additional consecutive upticks (as many as five or six) or until some some "size" appears on the bid. Sometimes the tiny upticks are throwaway shares from people needing an uptick to enter a short position -- not something you want to get caught in!
Very, very rarely will take a position in a stock that gaps the wrong direction (more than a couple of pennies) if you identified the stock via technical analysis. When doing postmortems on my own trading when I first started, I found my biggest losers were entered on days where the stock gapped the wrong direction on open -- for example gapping down the morning I intended to take a long position. Even if you apply these "wait and see" principles, a gap the wrong direction means something is fishy with the technicals.
Once again, patience is the key. Wait until you see a confirmed pattern emerge. The 1/2 point you might "give away" will more than be made up in just one or two dodged bullets. This particular strategy saves more capital than any other listed here.
Limiting the perpetual chase
The worst mistake most new investors make is chasing a stock. They will enter a limit order at $15 and the stock will uptick to $15 1/4. They'll cancel their limit order and then enter a new limit order at $15 3/4. By now, though, the stock has upticked to $16. They'll do the process again setting a limit at $16 3/4 (they'll show them!!!). The stock by that time may be at $17. Through sheer willpower and ego they'll eventually bid a number high enough to get filled.
Then they'll watch in disgust as the stock trades around their entry point for the rest of the day (if they are lucky and it doesn't retrace immediately) then slowly move back to $15 over the next session or two. They'll lament following some stupid web site's educational articles about how to patiently enter a stock, ignore their broker's advice about the prudence of limit orders, and swear to exclusively use market orders placed before the open from then on.
Their problem, of course, wasn't their entry strategy but their ignorance of their original profit goals. As a smart investor, you will already have upper profit targets and lower stop losses determined before you ever open the trade. The key here is to avoid entering the position beyond your pre-determined profit stop. If you're trading on technicals, your profit stop likely has some relation to the chart or to macro-market events. Just because the stock runs beyond the pre-set profit stop does not mean you can suddenly ignore them.
I know traders who not only set upper and lower stops, but also "chasing stops". They'll analyze risk and reward numbers for dollar values between the previous close and their upper target. Somewhere below the point of unacceptably diminishing returns they set their "chasing stop". If the stock runs beyond the chasing stop before they are able to enter the trade, they'll pass.
When you learn to be patient in entering trades, you'll certainly experience stocks running away from you. Being cognizant of your pre-set upper stops and their relationship to the technicals and markets AND having the discipline to honor that upper stop will make you a much more profitable trader.
After we published this article, I received several e-mails pointing out this advice was useful beyond just the short-term traders it was written for. I tend to agree since we continue to use these concepts when determining when to add or subtract weight on the companies in our model portfolio. The observation period is longer than a few ticks, but the principles are the same.
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