Entering The Trade

02/17/10 12:22:02 PM

by Alan R. Northam

There are three steps a trader must make in entering a trade. The first is to identify the trend, the second is to determine when to place a trade, and the final step is to determine the risk involved.

Security: JBHT
Position: N/A

The first step in placing a trade is to determine the trend of the security a trader is considering. There are many methods of technical analysis that can be used to determine the trend of a security, and one such is to use moving average crossovers. Figure 1 shows the stock chart of JB Hunt (JBHT). In this figure I have shown two moving averages. The 20-day exponential moving average (EMA) is used to measure the short-term trend and the 50-day EMA is used to measure the intermediate-term trend. The intermediate-term trend is defined as in a downward direction when the 20-day EMA crosses below the 50-day EMA. Intermediate-term trends normally last for several months and since these two moving averages crossed in late January, the intermediate-term trend is expected to move lower over the next several months.

FIGURE 1: JBHT, DAILY. This shows exponential moving averages and price peaks and price valleys.

Graphic provided by: AmiBroker.com.

With the trend of JB Hunt now in an intermediate-term downtrend, the price of JBHT is expected to continue lower. However, price does not normally move lower in a straight line. On its way down, price will normally move lower in waves that form lower high peaks and lower low valleys or troughs. I have shown these lower high peaks and lower low valleys on the price chart. Note that in a healthy downtrend, each successive price peak will be lower than the previous peak and each successive price valley will be lower than the previous one. It is only near the end of a trend that these previous peaks and valleys will be violated.

The next step in placing a trade is to determine the entry point of the trade. The lowest risk point to enter a trade is when price is pulling back to its 20-day EMA as JBHT is doing as shown in Figure 1. However, the exact point to enter a trade during a pullback can vary. I like to wait for the high of the price bar to move above the 20-day EMA before entering a trade. However, there will be times when prices will continue to move up through the 20-day EMA and move all the way up to and even slightly cross the 50-day EMA before turning back down. Under these situations, a small loss would be incurred as price continued to move up before turning back down. (Recall that in a downtrend, price should not move back above a previously made lower high price peak and should turn back down before reaching such a price peak.) Under certain situations, price will not even pull back as high as the 20-day EMA before turning back down. Under these circumstances, as soon as a price reversal bar forms, signaling that price is reversing back down, it would be time to enter the market. It is virtually impossible to time the perfect entry point, so don't be disappointed if the entry is a little early or a little late, as this is simply part of trading.

After determining the entry point, it is time to decide whether to enter the market short or long. In a downtrending market such as shown in Figure 1 for JBHT, a short trade should be placed. Long trades should only be placed during uptrends. An uptrend can be determined by reversing the procedure as described on how to determine a trend.

Once the entry point has been determined, it is time to determine a stop-loss point. A stop-loss is a point at which a decision is made to exit the trade if the trade is going against the expected direction. Under such circumstances, a significant loss of capital would be incurred if the trade was allowed to continue. The best price area to place a stop-loss is just beyond a price point that price is not expected to go during a pullback. Such a place is slightly above a previous lower high in a downtrend as shown in Figure 1, where price made a lower high in late January. Recall that in a downtrend, a price pullback should not move higher than a previous price high or peak. Therefore, this previously formed lower price high is an ideal area in which to place a stop-loss.

The last step in placing a trade is to calculate the risk of entering the market. The risk is calculated by dividing the entry price by the stop-loss price and expressing the result in percentages. In the case of JB Hunt, if a market order was set to enter the market at the last closing price of $31.68 and a stop-loss was placed at $33, the resulting risk of entering this trade calculates to be approximately 4%. Therefore, there is a possibility of losing 4% of the total dollar amount to be used in placing this trade. However, if the analysis is correct, the market will reverse back down before reaching the stop-loss point.

In conclusion, when deciding to place a trade, the first thing to consider is the main direction of the trend of the security being considered. The next step is to determine the entry point and the final step is to determine a stop-loss point. If the analysis is done correctly, price will turn back down in the area of the entry point and the stop-loss point will never be triggered. However, if the analysis is wrong, the stop-loss will trigger, resulting in a small loss and thus avoiding a large loss of working capital. There will be times when trades don't work out and losses incurred. However, there will also be times when the trade does work and profits result. Such is the life of a trader.

Alan R. Northam

Alan Northam lives in the Dallas, Texas area and as an electronic engineer gave him an analytical mind from which he has developed a thorough knowledge of stock market technical analysis. His abilities to analyze the future direction of the stock market has allowed him to successfully trade of his own portfolio over the last 30 years. Mr. Northam is now retired and trading the stock market full time. You can reach him at inquiry@tradersclassroom.com or by visiting his website at http://www.tradersclassroom.com. You can also follow him on Twitter @TradersClassrm.