Friday, November 28, 2014

The Three P's of Excellent Trade Execution

One of the best ways to gauge a trader's state of mind is by tracking his or her entry and exit execution.  Two traders can have the exact same idea and either make or lose money depending upon how they get into and out of the market.  Here are three P's that I look for in excellent execution:

1)  Planned - Do you have entry and exit criteria mapped out in advance, so that you know exactly your risk and reward at the time you enter a position?  Too often traders fool themselves into thinking they have a feel for markets and simply enter and exit when it feels right.  That means that they are entering when the market is going their way and exiting when it's going against them.  In a low volatility market, that leads to getting chopped up.  If you're looking for a great review exercise to improve your trading, track adverse price movement after your entries and favorable price movement following your exits.  If you're entering at poor times, you will see sizable adverse excursions early in the lifespan of the trade.  If you're exiting at poor levels, you will see the market move your intended way after you've jumped ship.  Such a review will tell you whether the feel you think you have is really providing you with an execution edge.  By planning entries and exits based upon tested criteria, good execution can become a part of your trading edge.  For instance, entering longer-term buy positions in stock indexes when the majority of shares are trading below their short-term moving averages shows more favorable return characteristics overall than going long when the majority of stocks are already stretched to the upside. 

2)  Patient - Is the trader patient about getting into and out of the market, or do they become fearful of missing opportunities and chase trades at bad price levels?  This is the natural outgrowth of planning.  When we have an execution plan, we have a grounding for patience.  We can choose to bet when odds are more favorable; stand aside when those odds are not present.  Without planned criteria, it is easy for entries to be based on greed and fear of missing out and exits to be predicated on pain.  A common problem faced by traders is dealing with the pain of gain:  the temptations to book profits prematurely.  This can lead to a deadly situation in which we let losses run longer than gains, ensuring fat negative tails in our P/L distribution.  When we are patient with planned entry and exit criteria, we don't have to be glued to screens.  That means that trading will deplete less of our willpower resources and we will be most likely to stay focused, in the zone, and grounded in good decision-making.

3)  Prompt - Once our criteria for entries and exits are met, do we act decisively, or do we become anxious and perfectionistic, hoping that good levels become great ones.  A common manifestation of performance anxiety is to wait for everything to line up perfectly before entering or exiting.  This rarely occurs, resulting in lost opportunities at entry time and suboptimal exits.  One advantage of planning trades is that it means you face risk and reward squarely before you get into the position.  Being at peace with the risk/reward profile of a trade makes it much easier to act promptly when our criteria are met.

One important point:  It is very possible to be an intuitive trader and also one that is planned, patient, and prompt in execution.  You may have a gut feel that stocks will break out of a range based upon patterns you've seen in the past.  That trade idea may be entirely intuitive, but the trade itself can be set up with planned breakout criteria and stop levels that enable you to be patient and prompt in getting into and out of the trade.  

And, oh yes, the chart above is a moving two-hour window of net buying and selling activity across all NYSE stocks from November 7th to the present.  Think of it as an intraday overbought/oversold indicator that is not price-based.  In an uptrend, the periods of net selling will occur at successively higher price levels.  That provides a nice basis for planned, patient, and prompt entry execution and highlights useful price levels for stop placement.

Further Reading:  Executing the Trade