Tuesday, January 12, 2010

The Trading Process: Executing the Trade

This is the fifth post in the series in which I outline my trading process. The prior four posts are:

Once you have the trade idea in mind, the next task is execution. (I will take up trade sizing in the next post in this series; obviously you have to size the trade before you execute). Execution means finding an entry point for the trade that maximizes your profitability and minimizes your risk exposure.

Above is an illustration of framing a trade for good execution, taken from today's market. We sold off hard in pre-market trading and then bounced higher at the open after sharp selling early in the session reversed. We move to the 1137.50 area in the ES contract and make several attempts to break through. Each attempt, however, occurs on lower volume, weaker NYSE TICK, and with weak participation of the other averages. This tells me that the buying is drying up below the 1139 area highs from pre-opening trade. At the very least, we'd expect a test of the morning lows around 1133.

The trade, then, enters to sell as near to the 1137.50 area as possible once it's clear that buying continues to dwindle. 1139 is an absolute stop, but in reality I would stop the trade out on an indication of increased buying (NYSE TICK) on increased volume. My first profit target would be the morning lows; my second target would be the lows from 1/8 (1131). This gives us a potential reward (move to target) to risk ratio that is quite favorable.

The key to the execution is:

1) Establishing the general trend for the day (down);

2) Waiting for a bounce higher that doesn't violate the trend (we stay below prior overnight high);

3) Waiting for buying to dry up on the bounce;

4) Put the trade on at a point where the distance to your stop-loss point is significantly less than the distance to your profit target(s) (favorable risk/reward).

Notice that you are taking the trade in the direction of the trend, but executing the trade in a countertrend style. That is, you're selling bounces in a downtrend. The reverse logic holds if we were buyers: you would be looking for an uptrend, waiting for a dip against the trend that stays above the prior low, waiting for the selling to dry up, and then entering the trade near enough to the stop loss point so that a move to the target will make you more than you plan to lose on the trade.

One beauty of good execution is that even with 50% winning trades you can be highly profitable, because your winning trades give you more than your losers take away. By executing with favorable risk/reward, you take the pressure of needing to be right most the time off your shoulders.