Chapter 2-3 Entering and Exiting Trades

It is important to use a checklist of some sort when deciding what and when to trade a stock.  It’s simple:  the more factors that meet your criteria, the higher the probability of the trade being profitable.  Often traders settle or focus on just one particular factor they like when trading, then get frustrated when the trade does not work.  If all the factors are not analyzed, a signal can easily be misinterpreted causing avoidable losses.  Thoroughly consider each of the factors listed below when deciding if and when to enter into a trade.

Identification of Proper Entries

  1. Exit Point – The most important thing when entering a trade is preparation.  You should be aware of what represents a successful entry and, more importantly, where your exit is at all times.  Some size should exist (at least a few hundred shares greater than your position), even look for a second exit behind your original exit.  This will help prevent slippage or squeezes.  Keep your losses small, you can always get back in the trade at a more opportune time.

Watch the prints (Tape) – Watch the time and sales prints.  These prints give the best indication of which direction a stock could be heading.  Example:  If a stock is strong for the day and an offer comes in to take out a bid, but the stock prints the order a penny above the bid.  This indicates that a crowd buyer stepped in front of that bid to buy at that offer.  This is an indication that more buyers exist and the stock will continue to trend upward.

  1. Limit Order Book (NYSE Open Book and Level II) – You should look for support and resistance levels created by larger than normal size on the limit book (both NYSE and Level II) that coincide with the chart.  Also, use the size represented on the limit book of both the NYSE and Level II to gauge a stock’s depth/thickness.
  1. Chart – You should be trading with the trend.  If the chart is trending up the higher percentage trade is to go long.  If the chart is trending down the higher percentage trade is to the short side.
  1. Range – Look for stocks with an intraday range of at least $0.75.  The range is defined as the difference between the high and low print.  Trading stocks with a low level of volatility, or tighter range, will most likely result in a loss and possible missed opportunities elsewhere.
  1. S&P 500 Futures or SPY – The S&P Futures or SPYs should be going with the trend of your position.  If you are long, the market should be trending upward.  As an exception to this rule, a stock can trend against the market if it is exhibiting greater than normal volume on the day, as it most likely extremely strong or weak for the day.
  1. Sector Watches – You should know what sectors are strong and weak on the day and look to take positions that coincide with the sector trends.  Example:  When the steel sector is strong you should look for entry points to go long in steel stocks and vice versa when the sector is weak.
  1. Time of day – This is very important because most real moves take place from 9:30 am to 11:00 am then from 2:30 to 4:00 pm.  Be careful trading during lunch hours unless the day is very active.
  1. Momentum – You should take into account the speed in which the stock is moving.  You do not want to get stuck trading a slow stock during the open or close, because there are probably numerous other trades in which you could enter that could produce greater rewards.  Extremely thick stocks usually do not have a lot of momentum.   Moreover, time of day typically affects a stocks momentum.  In the middle of the trading day most stocks slow down considerably.  Stocks are much more free-flowing during the first and last hour of the day.

Exit Signals

When entering a trade an exit should always be identified in order to protect against a significant loss.  It is essential to place exits at logical prices that coincide with the information given from the equity itself, whether it be from the chart, the tape, the limit book, etc.  Depending on your execution, an exit can positively or negatively impact your trading day.  Having the discipline to adhere to your money management guidelines will be critical to continuous success.

There are many different scenarios you must learn to recognize to continually put the odds in your favor.  You must learn to read and react to the market.  Learn to read what the story that is being told by the tape.  Moreover, look for affirmation on the Limit Order Book and Level II.  If numerous indicators all confirm a decision, probability of success dramatically increases.

Here are a few basic examples of when to exit your position.

  1. After entering a long/short position, the exit that you have identified has disappeared from the Limit Order Book and the stock price starts moving against your position.
  1. When long/short a stock you should exit, or lock in at least some of your profits, when there is a large gap or spike up/down and a large print or prints (typically totaling 10,000 shares or more) occur with no support/resistance immediately stepping in to provide protection from a move right back in the opposite direction.
  1. There is a failed breakout/breakdown of an anticipated move with large prints (typically totaling 10,000 shares or more) with no significant price increase/decrease.  As a result, this stock will most likely be reversing its trend.
  1. If long/short a position and significant size of 10,000 to 50,000 is offered/bid.  This most likely will reverse the trend, at least in the immediate future.  Whether the large size is simply placing the order to exit the position or is looking to participate in the opposite direction of you, neither is a favorable scenario.
  1. If long/short a position and your exit is in the process of being eliminated due to aggressive selling/buying it is wise to get out immediately in order to prevent a significant loss.  When momentum is allowed to build up in the opposite direction, a significant spike can occur the very second the level is broken.  Thus, to prevent serious slippage, exit when there are signs that a level is in the process of giving way.

Remember, keep your losses small!  If you are constantly giving positions 20 to 25 cents of space, then you must be making a minimum of 60 to 75 cents in your successful trades.  We encourage tight stops/exits to minimize losses, which will increase your chances for success.  Utilizing the 3 to 1 reward to risk ratio will help you decipher the good trading setups from the bad ones.

Stop Placements

Stops are a very useful tool to help you control your risk.  However, it is crucial to place stops effectively.  Placing stops where other traders can easily tick them will cause unnecessary losses time and again.  You must learn when and where to place a physical stop and let the move play out in order to produce significant profits.

There must be a proper setup for placing the stop.  Here are the 3 basic criteria for ensuring proper stop placement.

  1. The trade should be in the money at least 5 cents.

Having positive separation from your entry is critical to proper stop placement.  If you have a stop too close to the last trade price it might get executed and this will take you out of the trade prematurely.  You will then have to reenter the stock at a less appealing price thus decreasing your profitability.  Therefore, if it is possible, wait until you have some separation before you actually place your stop.  Keep in mind that your exit might disappear, which will then force you to have to adjust your stop accordingly.  More volatile stocks require you to place your stop further back when trailing the price to prevent getting shaken out of the position.  If there is no significant profit potential consider tightening you stop and scalping the position for a small profit instead.

2.   The stock, sector, and market should be establishing a trend.

When you place a stop consider the current price trend and upside/downside potential for the position.  Trade in the direction of the sector.  This gives you the best probability of profiting from the position.  If the stock tends to follow the S&P Futures trade with the sector and the overall market.  Place stops slightly behind new levels being created.  For example, if you are long CAT from $57.85 and the stock breaks through a major resistance level at $58.00 and now prints $58.15 consider putting a stop below the previous level of resistance which should now act as support.  Thus, placing a stop around $57.99 would make the most sense as the previous level at $58.00 should provide protection.

  1. There must be some significant size, at least equal to the amount of shares of your position, for an exit.

It is essential to place stops only at prices where some share size exists on the limit book or ECNs.  Do not place stops at prices where stock is not present.  Doing so will cause slippage as you will not receive an execution at your desired price.  For example, if you place a sell stop order for 600 shares of CAT at $57.99, but there are only 200 shares at $57.99, then, at best, it can be expected that you will receive only a fraction of your exit at your desired price of $57.99, with the remaining shares likely to be filled lower.  How much lower will ultimately depend on the speed and liquidity of the stock itself, but, nevertheless, a poor exit can be expected.  Also, keep in mind that educated traders tend to know where stops are most likely to be placed, so in order to protect your gains you need to have a sizable exit that can absorb a flurry of orders to ensure you receive your desired price.

Stop placement is up to you as the trader.  The proper placement of stop orders can protect gains and prevent uncontrollable losses.  As a trader there are two distinct ways you can place stops.  You can choose to use physical stops or mental stops.  Physical stops are orders you actually submit to the exchange.  These orders sit dormant, waiting to be executed should your set price be breached.  While mental stops work in a completely different way, which requires a great deal of discipline on behalf of the trader.  Mental stops are prices in which you set for yourself to exit.  With mental stops no order is sent until the price you have decided has been reached.  Obviously, if you lack the discipline or focus to exit when the time comes, you could sustain unnecessary losses with mental stops.  The advantage though with mental stops over psychical stops is that you avoid being stopped out of a position by random small arrant prints.  Thus, with mental stops skilled traders are often able to use tighter stops than with psychical stops.  Whether you prefer one type of stop or the other, it is important that some type of stop is used at all times.  Being able to control your exits is essential for trading success.