Introduction to Identifying Low Risk Entry Points
We have already discussed using multiple time frames to improve your entry timing, but there are other entry techniques that can improve your trading and your probability of success. The key here is to identify low risk entry points.
Identifying Low Risk Entry Points as a Share Trading Technique
Low risk entry points are points at which you can enter the share market and quickly identify when the trade is not going as planned and exit for a small loss. There are a few techniques that can be used to determine these entry points.
The majority of people think in straight lines, projecting the past performance into the future. When the bull stock market has been running for a few years everyone is talking about the money they have made and how much they will have in the future. When the stock market has been down for 2 – 3 years no one wants to buy stocks as the fear is that the stock will continue to go lower. But this thinking is completely out of sync with the way the market actually functions.
Markets move in cycles and as an investor or trader you must learn to think in cycles. At the peak of a market, investors tend to over-project the future. In the middle of the cycle projections and reality are in alignment, and then the pessimists take over and project that the likely path is much worse than it is.
Markets move in cycles
So how can an understanding of market cycles help us when trading?
Well it has a significant effect on when to enter a trade. The beginner often chases a stock as it moves higher and jumps on board just as the stock falls over. If you’re following the market cycles you can get on board the stock as it turns higher and begins to rise. Remember this is the stage when the stock market is underestimating the up move. Once the stock starts to lose momentum, then it’s time to take an exit while the market is still anticipating further upside.
Bourse software: cyclical nature of movement
Notice the cyclical nature of movement of the S&P/ASX 200, as viewed in the Bourse charting software during the last 8 months. A move to a new high is followed by a move down and then a recovery back up. The stock market has not exhibited a strong trend in any direction but this is normal for markets with periods of consolidation far more common than strong trends.
Identifying share price movement – the rubber band theory
Another way to consider the cyclical nature of market movements is to consider that the share price is attached with a rubber band to a trendline or a moving average. When the share is a long way away from the reference line the rubber band is stretched. When it is close to the line, the rubber band is relaxed. A stretched rubber band is most likely to snap back and a continuation is extremely unlikely. Occasionally the rubber band will break, but the probability is in favour of the market reversing from an extreme. Entering as the stock turns higher off the trendline provides a low risk entry. If the stock then falls below the trendline you know very quickly that your trade was wrong. If you enter after the share has moved up, you must wait for the market to pull back to the trendline and then break below to determine whether you were wrong. The cost of a mistake here is far greater than the previous entry and as a trader you are taking on a much greater risk.
Bourse software: hourly chart of the ASX 200
In this hourly chart of the ASX 200 from The Bourse, the market is sitting on the trend line at 4559. This provides a low risk entry point as a stop could be placed just below the trendline and the round number of 4550 to maintain a risk of around 15 points. This is not a guarantee that the market will rise from here, however if it doesn’t rise then you will know very quickly that you were wrong.
Low risk entry points can be used to dramatically improve your trading results. There are other low risk entry points that will be covered in future editions of the Trader Dealer Newsletter so make sure you look out for these!
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Jeff Cartridge
Education Manager
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