As a market watcher and active trader I have observed that there are times when I am certain the market will move higher and other times when I am sure it will move lower – though most of the time I have no idea what is going to happen next. Markets are trading around the clock and there are many opportunities to profit, but it becomes absolutely necessary as a trader to specialise and narrow your focus. It is important to let half-rate opportunities pass you by and act only when the signals all line up and scream out buy. Chasing the half rate opportunities eats into both your account balance and your confidence.
Every time you enter a trade you are choosing to place some of your capital at risk. I’m sure by now you’re aware that it is critical to know how much capital you have at risk on each trade, so I won’t repeat those rules again today. The whole purpose of placing your capital at risk is to gain a reward. And if you’re a successful trader then you have learnt to balance risk against reward. And this is where things get interesting.
Your aim when trading is to minimise your risk and maximise your rewards. This is illustrated in a random entry strategy that buys any share and then sells it three days later. If you keep repeating this process, you can say you are a trader. But the net results are likely to be very poor. If the market is bullish you might make money with this approach, but if the market is bearish there is an excellent chance you will lose. Some shares you buy will go up a little, some more and some a lot, while some shares will go down a little, some more and some a lot. Overall this tends to cancel out, but what if you cut out your large losing trades. All of a sudden your results are skewed to the upside. Small losses and big wins can lead to very profitable trading. At this point it becomes tempting to place tight stop losses to cut off your losing trades, but too many losing trades and you are also going backwards quickly.
Let’s consider another way to balance the risk reward equation by refining your entry technique. Wait for the right trade to come along before ever placing an order. While you may have to wait forever for the perfect trade to arrive, the best trades all have one common characteristic. Whether the trade wins or loses is unknown when you enter the trade, but the risk you are taking is clear. A low risk entry opportunity will always outperform in the long term, because you are only taking on a small risk with a chance of making a reward. What does a low risk entry point look like in the wild? Oops! I mean, The Bourse.
A low risk entry point is one that you will quickly tell you if you got it wrong or not. It’s extremely difficult to pick the exact turning point in any market, but the price movement after your entry will confirm very quickly if you are right or wrong. As an example an entry near a trend line is a low risk entry point. If the price moves below the trend line then you know very quickly you are wrong and can exit safely with minimal risk. In a similar way if you enter as a share bounces off support or resistance, you know you are wrong if it breaks through that level soon after. And when the share you are trading reaches an extreme and turns around this is another low risk entry point as you will quickly be proven wrong by a move to a new low.
In the chart of Commonwealth Bank (CBA) the first line marks the peak in the Money Flow Index shown at the bottom of the chart. This is an extreme that occurred in April and a small pullback from this level began to develop. It would be possible to short sell CBA, using options, warrants or CFDs, but it did not go as planned and CBA moved higher and this trade would have been exited for a small loss, unless you exited quickly.
The next time the Money Flow index reached an extreme was in May and the trade worked out better as this pullback developed some strength. The top trend line could now be drawn. The Money Flow Index then peaked again and coincided with hitting the downwards trendline. This is an excellent trading opportunity as two low risk entry opportunities line up. However it took two months for this opportunity to arise in July. Would you wait for two months for a trade? Remember good things are worth waiting for. And one last opportunity appears in mid July – this time for the buyers which could have resulted in a quick gain for short term traders who exit quickly.
Right now we are in no man’s land, and there are no low risk entry opportunities in CBA. The Money Flow index is sitting in the middle of the road and a significant move could occur in either direction. Be patient and wait for the next low risk entry opportunity to arise. And for the impatient there are other shares to follow, but stick to the same rules.
By Jeff Cartridge
Education Manager
