Friday, February 02, 2007

Three Qualities of Good Trade Execution

Here's a look back to my Market Delta chart for the short trade that I placed on Thursday morning. The market had moved steadily higher in the early morning and then steadied ahead of the release of the ISM report. When the report was released, we saw sellers come into the market with size. This shows up in the Market Delta chart as a red color within the bars. Red occurs whenever the first number within the bar (the number of contracts transacted when that price is the market bid) is greater than the second number (the number of contracts transacted when that price is the market offer). After a bounce in which buying did not attract significant volume relative to the volume during the decline, this offered a fine opportunity to go with the flow of the sellers. Shortly after, fresh sellers hit the market again with size. A more meaningful bounce then occurred, followed by two more bouts of selling that could not push price lower and that occurred on lower volume. This was my signal to cover the short position.

The trade illustrates three qualities of good trade execution:

1) It exploits immediate market conditions - Buyers had been bidding the market higher. Any good news from ISM was priced into the market. Once sellers hit the market, the short-term momentum shifted to the sellers. This led to a situation in which many participants who were long the market would exit their positions. The trade, catching the shift early, was able to exploit this disgorging of positions. Many of the best intraday trades are ones in which you catch a shift in buying or selling interest and can front run longs or shorts getting out of their positions.

2) It limits risk by having a clear stop loss point - The ideal stop point is that point that tells you your idea was wrong. If we had suddenly gotten a spurt of volume lifting offers (green color on the Market Delta chart) shortly after the sellers hit the market--or certainly if we made a new price high after the ISM release--my idea would have been invalidated. Once you see selling dominate, the bars should stay red. Otherwise, the volume flow is not in your direction and you do your best to limit losses. You want your entry to be as close to the point that would prove you wrong as possible, so that your risk:reward ratio is always far better than 1:1.

3) It holds onto profits by having a clear set of exit conditions - My initial price target was the low of the overnight range at 1442.5. I also, however, exit trades if, over a period of 10-15 minutes, I do not see volume continuing to expand in the direction of the trade. (I often think of this as a "three strikes and you're out" rule in Market Delta. If three consecutive bars can't push the volume flow and price my way, I get out). I knew that the overall market trend was not down, so I did not hold out for my price target. I let the market tell me where buying and selling were expanding and drying up and took what the market gave me on that trade.

Of course, much more goes into a good trade than execution. I'll tackle that in another post. The important takeaway here is that good execution can minimize losses on wrong ideas and maximize the potential of good trade ideas. Much of a trader's profitability comes, not from the setup ideas, but from their proper execution.