There are two types of markets in which a trader will trade - a trending market or a sideways market. On any time frame, a trade may be held through both types of market, but it is when the trade is entered and in what type of market (trending or sideways) that determines its level of risk. Risk is simply the amount of price movement we would expect before we can say with some certainty the trade is not moving in our direction (at least for right now), and is moving because of factors beyond simple market noise. (To learn how to trade a sideways market, read Finding Value In A Sideways Market.)
In this article we will look at how risk can be established in a trend using two simple entry strategies.
In a trending market, several tactics can be used to establish risk. The longer the time frame anticipated for the trade, the longer the time frame that should be used for establishing the risk and reward for the trade. This will allow the trader to avoid being whipsawed in and out the market. If the trade is being viewed as an investment for the long term, weekly or monthly charts should be used to analyze it. If the trade is an intraday trade, then a one to five-minute chart - and possibly an hourly chart - should be viewed to gauge the context of the trade.
In trends, the most common way to establish risk is to take the entry price minus the most recent swing low for long positions and the most recent swing high minus the entry price for short positions. Then, multiply this number by the number of shares the trader is exposed to. A small cushion should be added to the high/low to allow for moderate flucations. If a former swing low is penetrated in an uptrend, there is a possibility that the trend is reversing, or at minimum the trend is in some danger of ending and thus the trader should exit the trade until the trend re-establishes itself with conviction.
The definition of an uptrend is higher price highs and higher price lows. In a downtrend, price makes lower highs and lower lows. So, if you enter a trade in an uptrend and a previous low is penetrated, this is no longer an uptrend by definition, thus the trader should exit and wait for the trend to re-establish itself. This will be signalled by price moving higher than a former swing high. (For more, check out Candlesticks And Oscillators For Succesful Swing Trades.)
Entering In An Uptrend
Entry in an uptrend is often established when price exceeds a former swing high. Entering at a high may seem counterintuative; after all, why pay the highest price of recent movements? However, this is of no concern to the trader, as price is relative. In order for a price to move back to an old high and then beyond an instrument must be valued highly by the market. The fact that it could have been bought cheaper before is of little concern, for it is the very fact that the instrument has climbed back to a former high that makes the instrument worth paying attention to. Climbing to and past a former high brings in new and old buyers as they have been proved right and are scared to miss the coming upward move. It is also likely to sqeeze out any short positions as they have been proved wrong for the time being. This will push the instrument in an upward direction.
Unfortunately, theory does not always play out in the real world. The downside to this entry is that if prices turn and begin to move in the opposite direction of the trend, our risk is greater than what it would be if we used an alternative, lower, entry point.
Entering On a Sideways Trend
An alternative entry method is to use trendlines, and then enter trades when a trendline holds, and prices bounce off the trendline in the direction of the trend. The advantage of this entry is that we are entering into a move sooner, and therefore our risk will be smaller because we are entering closer to a recent swing low (in the case of an uptrend).
The downside is that we do not know whether the trend will continue, as prices may move only slightly higher, but fail to push above the rent swing high. Another contingency we need to be aware of is that trendlines are not always perfect - prices may not reach a trendline every time, thus making the entry more subjective, or prices may bounce off a trendline only to reverse and move through the trendline. We may also have multiple trendlines, as markets often break below one trendline only to be supported by a new one as is the case in Figure 1, which shows several potential entries. (For more, read Track Stock Prices With Trendlines.)
|Figure 1: SPY hourly chart|
|Source: Free Stock Charts|
Putting It Together
Some traders favor one method over the other. It is also possible to trade both methods in conjunction with one another. Half the position can be taken on a trendline bounce, and the other half of the position can be taken when a new swing high (or low) is established in an uptrend (or downtrend). This allows for part of the position to be established early in a move, while the other portion of the position will only be acquired if prices confirm they are in fact moving past old highs or maintaining the trend. If prices do not move past former highs, the loss is quite small on the initial first half of the position. And if prices do continue to rally, the profits can be large, especially on the portion acquired at the lower price.
Of course, as mentioned earlier, the downsides to these entry methods are still there. Prices can turn at any time, no matter what confirmation we have received. Thus, it is very important to keep a stop loss on all trades, and when there is an indication that a trend is not going to continue, the trade(s) must be exited.
An uptrend is when the price movement shows higher highs and higher lows. Based on this we can establish our risk before entering trades for as soon as higher highs or higher lows are not occurring we should no longer be in a trend trade. When the trend is intact we can enter on new highs, or we can enter as prices bounce off a trendline in the direction of the trend. We can also use these methods in conjunction with each other, taking part of the position at the different entry points. Prices are constantly moving, so it is important to use stops and exit trades when the trend shows signs that it is reversing. (For more, see Trading Trend Or Range?)