Let’s look at some basic advice for entering a trade.
ENTRY: Should be in the direction of the trend. No special indicators required, enter at any time.
- The stock should be trending in the direction you intend to trade.
- The market should be trending in the direction of your trade or sideways.
- Avoid entry on days the stock moves opposite the direction of your trade as it could continue or be the start of a reversal. The exception is when a stock is hit with news and has a HUGE (Donald Trump voice) overreaction. It is almost guaranteed to make up a good part of the overreaction. By overreaction I don’t mean a stock that is broken: rules violation, E.Coli outbreak, oil leak, etc. These types of overreaction can last days, weeks or forever.
- Our priority is not the entry, it is the exits and position sizing.
OK, you are ready to enter your perfectly chosen stock. But first, you look for the “perfect” entry point. The moving averages have crossed, the MACD looks good, the “talking heads” are touting now is the time and there is a full moon. All your requirements are satisfied so you pull the trigger.
How important is technical analysis for an entry? What about fundamental analysis or sentiment? In my opinion they all contribute to a degree, but the most important factors in making money is money management and managing your exits. The entry, no so much.
First, understand that technical analysis is all based on just two things – historical price of the stock and/or historical volume of the stock. As such, it tells you what has happened, not what will happen. Past performance is no guarantee of future results. Even momentum is a late entry. By the time you have identified that a stock is in a trend and enter the stock it can reverse.
If you ask Warren Buffett, The Motley Fool or even Jim Cramer, they will tell you to find a good stock based on fundamental analysis and buy it. Does Buffett wait for a MACD signal before purchasing a company? You are purchasing the company also, albeit on a much smaller scale.
I believe the real value in technical analysis is exposing the psychology of the market participants, both past and present. Because so many people use technical analysis it becomes a herd mentality and sometimes a self-fulfilling prophecy. The stock is “stuck under the 200,” there is a “head and shoulder” pattern so sell (which is statistically a loser, sorry). It’s not that the chart patterns themselves are somehow making the stock move in a certain direction, but because so many investors believe the pattern they react accordingly and the stock responds in kind.
So, how does this effect your entry? David Winton Harding, British billionaire and CEO of Winton Capital Management, said in an interview, “If you put in stops and run your profits and trade randomly you make money; and if you put in targets and no stops, and you trade randomly you lose money. So the old saw about cutting losses and running profits has some truth to it.”
I have seen several sites that have done studies exploring random entries using a coin toss for entering long or short and then exiting based on some sort of stop loss. Here is one such test of Mr. Harding’s statement comparing random entries with trailing stops vs random entry and random exit vs an entry from moving averages. The trailing stop was a 39-day (exponential) ATR set at 2 ATR.
|Random Entries / Trailing Stops||16.14%||23.12%|
|Random Entries / Random Exits||-0.26%||10.49%|
|Random Entries / Profit Targets||-7.94%||89.03%|
|MA Entries / Random Exits||2.36%||59.76%|
|MA Entries / Profit Targets||-10.46%||93.05%|
CAGR = compound annual growth rate
Max DD = Maximum account draw down
From “Further Musings on Randomness” by Jez Liberty
Dr. Van K. Tharp is arguably the “guru” when it comes to money management and psychology in the stock market. He has written several books and is a trading coach and consultant. Tharp expanded on a comment by Tom Basso in 1991, a hedge fund manager and founder of Trendstat Capital Management, wherein he stated the most important parts of his system were his exits and his position-sizing algorithms and that he could do well with random entries.
Tharp developed a very simple system. Random entries using a coin flip to determine long or short. A trailing stop of 3 x ATR (10-day exponential moving average), and a 1% risk algorithm to size positions. He ran this in 10 different markets over 10 years. It made money 100% of the time.
Chuck LeBeau and David Lucas in, Technical Traders’ Guide to Computer Analysis of the Futures Market, also studied various entries against random. The only exit was to exit at the end of 5, 10, 15, and 20 days later. They were just looking to see if the entry was superior to random. None of the indicators – oscillators, moving-average crossover combinations, channel breakout – were statistically better than a random entry.
Tharp did mention that visual analysis beat random. Visual means looking at the chart of prices, no indicators, and if there is a clear trend, enter in the direction of the trend. While not statistically tested there are some entries used by well-known systems that might be a little better than random: channel breakout; volatility breakout in a single day, a large ADX movement in a single day; increasing velocity in direction of the trend. But, it is very hard to beat random in the direction of a clear trend.
The point of this exercise is NOT to have you just randomly enter a stock and hold on, but to let you know that developing a complicated system for entry is pointless. The only indicators I use are the 200 and 20 moving averages. For reference I have developed an indicator telling me the slope of the stock and another indicator marking the stock highs and lows. That’s it.
I only buy long (I do short in my personal trading account) as a retirement account only allows long positions (yes, you can buy a “put” which is like shorting, but that’s a more advanced topic) and I never buy a declining stock that I have no current position in. I will add to a declining stock that is moving with the market and has not violated any significant low. Again, these topics and methods are part of other discussions.
I hope that this has helped you in your trading career.
James Krider, MD
Krider Wealth Management