While finding a trade is only part of any plan and there are many ways to go about this, identifying when the trade should be entered is a crucial feature. This is usually described as timing and can be one of the most frustrating parts of trading for experienced traders as well as newcomers. This will be particularly the case if you continue to think that being right means anything. Because it will be a regular occurrence that you are right about what the market will do, but lose on the trade due to a timing problem.
In truth there are probably as many timing strategies and styles as there are traders, but different approaches are commonly categorised under various headings that appear regularly in the literature. Here are some of more commonly encountered.
Breakouts
The concept of support and resistance is one of the first technical ideas any trader will encounter and is often intuitively accepted even by traders who primarily use fundamental analysis. The CANSLIM approach discussed below it a good example of this. Entering a trade on a breakout basically means identifying a price level such that a move by the security beyond that level indicates that a further move of relative importance is likely to occur in that direction. Because the breakout indicates that a move has started in a defined direction it is a popular approach to timing.
Breakouts are therefore highly compatible with trend following and indicate a time when a pullback has ended or a period of sideways movement gives way to a trend. They may also be final confirmation that a long term trend has ended. However, it is important to ensure that any breakout is supported by confirming factors. Depending on the style of trading being used this may be momentum, news, an increase in volume or some other relevant factor.
Retracements
A retracement entry strategy is somewhat more complex. Again it helps to have identified a support or resistance level. But it is also necessary to have identified a trend that you are confident remains in place. The basic rationale is that no trend proceeds in a straight line but pulls back every so often. Sometimes this pullback, or retracement, may end at a recognizable trendline but there is no guarantee of this. Often it is necessary to watch for a loss of momentum in the pullback using a timeframe at least one level shorter than the timeframe that is used to identify the trend. The key information is to identify a signal that the retracement is over.
Entering on a retracement may have a somewhat lower success rate than from a breakout but the benefit is that there is a better risk reward ratio. A close stop can be used since a further move in the direction of the retracement simply means the pullback is not over. If the trade is successful then it is being entered right at the start of the move, well before any breakout occurs.
Channels and Reversals
These are usually thought of as distinct but I will treat them together here. The key requirement is that there is no trend – the market is trading in a channel, sometimes described as a trading market – or a trend has weakened or ended and the trader assumes that it will reverse. Again some form of support or resistance needs to be identified. The assumption is that the market will hit that level and will not break through. Low levels of momentum or low volume will increase the confidence of entering when the level is hit as the market will not have sufficient power to break through. Having a clear, firm exit strategy is essential as the trade will be fairly short term. There is no trend to support staying with it long term and the channel will have an opposite extreme. This target should be treated as a firm level and not usually extended.
Momentum
While momentum is a key input into the entry decision in the above strategies and is also considered a distinct trading style in itself, it is particularly important in timing trade entry. The main difference is that much less attention is paid to identifying a particular level such as support tor resistance. Instead the emphasis is placed on the behaviour of a preferred indicator such as MACD. A trend should first be identified and only trade in line with the trend. A move of the indicator, such as a cross of a line or a move to an extreme is taken to indicate that the trend is strong or strengthening and so price is likely to continue to move in this direction. In contrast, a divergence suggests that the trend is weak and you should consider exiting an open trend.
Momentum is a very flexible approach as it does not rely on the market approaching any particular point and, if used properly, there is a good success rate. Key requirements are that there is a trend and that the indicator(s) are used in an appropriate manner. It’s usually best to rely on just a small number and not try to complicate the process. Hard stops should be used but the target can be adjusted as long as there is no indication that the trend is weakening. It’s also best not to use this approach if the market is approaching a known support or resistance level, if the trend is overly extended, or if a major news announcement is imminent. Be careful also of entering momentum trades on low volume.
Position trading
Position trading would normally be considered to be somewhat more long term. The objective here is to be in the market even before a move takes place. As such, the analysis tends to be based on fundamental factors. If the move then begins, technical approaches such as breakouts or momentum can be used to further build the position. This implies that the initial position is not sufficiently large enough to exhaust your full risk tolerance, or that the initial stop is moved closer before a new entry.
In some respects this strategy looks similar to momentum or trend trading but the difference is that the initial entries are made before those strategies would indicate. As the trade progresses, retracements may also be used to build the position. Position trading is therefore quite a sophisticated approach as it relies on fundamental analysis and various uses of technical tools. The big advantage is that very good risk reward ratios can be obtained.
These approaches can seem quite similar and indeed there are similarities. However, each has essential features and precision requires that a trader is clear about which approach they are using and implement it accurately. As a result, it is probably best to try to concentrate of developing proficiency in one or two approaches rather than hunting around to find a model to fit every market.