Chapter 12: Entering & Exiting a Trade
In this final chapter, we’ll outline a simple process for utilizing technical analysis in trading. Whether new to the markets or experienced, structuring your trade correctly can improve your trading decisions. We’ll also discuss choosing the right timeframe based on your objectives.
We aim to provide a step-by-step guide on integrating the learned concepts into your trading strategy. You’ll navigate the markets more effectively by learning when to enter or exit trades, setting stop-loss levels, and identifying market trends. We’ll also cover risk management.
Defining your objective & selecting the right time frame
Three factors that significantly shape our trading objectives are:
- Financial objectives
- Time commitment
- Risk tolerance
Financial objectives
Are you viewing the stock market as a long-term investment or aiming to achieve a certain income level through trading? Your financial objectives influence your trading strategies and risk management selection, helping you set realistic, achievable goals. Whether you seek steady, long-term growth or quick, short-term returns, your goals will define your approach to the market.
Time commitment
Only some people can sit in front of a screen from the market open until 3:30 PM; we all have different schedules and responsibilities. This factor will largely determine your trading style—intraday, swing, or long-term investing. Understanding your available time will help you choose a trading approach that aligns with your lifestyle and daily commitments.
Risk tolerance
Lastly, your risk tolerance plays a significant role in shaping your objectives. If you have low-risk tolerance, then safer, long-term investments focusing on capital preservation is a good option. On the other hand, if you are comfortable with higher risk, pursuing an aggressive trading strategy aiming for higher returns would be more suitable. Understanding your risk tolerance will ensure your trading style aligns with your comfort level and financial stability.
Choosing the appropriate time frame becomes relatively straightforward if you decide on an objective in trading because they are closely linked. For instance, if someone aims to make quick profits, they prefer shorter time frames, such as intraday or swing trading. This involves frequent trading within minutes, hours, or days, requiring a more active and immediate approach. On the other hand, if the goal is steady growth and capital preservation, a longer time frame, such as positional trading or long-term investing, might be more suitable. This approach involves holding positions for weeks, months, or even years, focusing on fundamental analysis and broader market trends.
Here is a summary of all the timeframes and how much time should be ideally dedicated to them:
As a thumb rule, the higher the timeframe, the more reliable the trading signal is. For example, a bullish engulfing pattern in a 15-minute timeframe is far more trustworthy than a bullish engulfing pattern in a 5-minute timeframe. Keeping this in perspective, one has to choose a timeframe based on the intended length of the trade.
Lookback Period
As a beginner, it can be unclear how many candles to consider for trading. The lookback period is the number of candles you review before trading. For instance, a lookback period of two weeks means you analyze today’s candle within the context of the past two weeks of data. This helps you understand today’s price action with respect to past market movements, giving you insight into shorter-term trends and potential price patterns.
For swing trading opportunities, an ideal lookback period is between 6 months to 1 year. This timeframe provides a comprehensive view of market trends and potential setups, helping you make well-informed trading decisions. In contrast, for scalping, focusing on the last five days of data is more effective, as it allows you to capture the most recent price movements and respond quickly to market changes.
When plotting support and resistance levels, extending the lookback period to at least two years is essential. This longer timeframe helps identify significant historical levels that could influence current price action, ensuring a more accurate analysis of potential market behavior.
Trading Universe
There are ~5,000 stocks listed on the Bombay Stock Exchange (BSE) and ~2,600 on the National Stock Exchange (NSE). It’s well known that scanning for opportunities across thousands of stocks daily can be overwhelming. Over time, narrowing down on a set of stocks you feel comfortable trading in is essential. This set of stocks becomes your “Trading Universe.” By focusing on this specific universe, you can more effectively scan for and identify potential trading opportunities daily, making the process more manageable and focused.
Here are some key pointers to keep in mind while defining a trading universe:
1. Make sure the stock you’re trading in is liquid. You need someone to sell when you’re buying and buy when you’re selling.
- One way to ensure this is to gauge the bid-ask spread; the less spread, the more liquid the stock is.
- Another way would be to check the volume, i.e., the number of shares traded. Many traders set minimum criteria of considering only those stocks with a daily volume of at least 50,000.
2. Ensure the stock is in the ‘EQ’, i.e., equity segment, which allows for day trading. Stocks that are part of the F&O segment are subject to getting banned for intraday trading. While day trading isn’t recommended for beginners, sometimes you may start a trade intending to hold it longer but find that your target is reached on the same day. In such cases, closing the position within the day is okay, which is possible with ‘EQ’ segment stocks.
3. Try avoiding operator-driven stocks. Unfortunately, there is no quantifiable method for identifying operator-driven stocks. Staying updated with the latest news can help you avoid such stocks.
It is recommended that you start with the Nifty 500 as your opportunity universe, especially for swing and positional trading, as most stocks in this index comply with the above 3 criteria.
Nifty 500 is a stock market index in India that showcases the top 500 companies listed on the National Stock Exchange (NSE). These companies are chosen based on their market capitalization, which measures a company’s value in the stock market. To calculate market capitalization, you multiply the company’s current share price by the total number of its outstanding shares.
Nifty 500 has various stocks from all the sectors IT, financial services etc.,
Trading process
Let’s discuss how to select stocks for trading, similar to applying filters while finding your favourite product on an online marketplace.
Assuming we are swing traders, let’s recap defining our objectives, shortlisting a stock, and taking a trade. This means that:
- Our objective is to make quick returns over a few days or weeks
- We would have to give 1-2 hours per day for market analysis
- We can tolerate moderate risk
- Our trading universe would be the Nifty 50
- Our lookback would be between 6 months to 1 year. We would be looking at the past 1-2 years while plotting the support and resistance level
Here’s a good process you can follow:
- First, create a watchlist from the Nifty 500 universe. Recall that we need liquid stocks not part of the ‘F&O’ segment. We can add more conditions to trim our watchlist further. We feel confident trading on a positive day, so we will add another criterion of the stock being bullish on the current day. You can use other filters as well. Some examples are choosing stocks trading with above-average volumes on that day, looking at stocks from a specific sector, or using indicators, like only shortlisting stocks whose RSI is above 70.Many stock scanning tools will help you filter stocks based on your criteria. We created the following scanner to shortlist stocks as per the criteria we mentioned: https://chartink.com/screener/nifty-500-swing-trading-beginner.
- Next, look at the stocks’ charts that the scanner shortlists. As of this writing, our scanner has shortlisted 43 stocks.
- While looking at the stock charts, try plotting the support and resistance levels. Remember, a lookback period of 1-2 years is deal for this.
- Next, look at the latest 15-20 candles. Is the stock forming higher highs or lower lows, or is the trend looking like it’s changing direction? Once we know the stock’s momentum, notice the latest 3-4 candles. Is there a candlestick or chart pattern being formed?
- If you find any recognizable pattern, shortlist this stock for further investigation.
The final step is to analyze all the shortlisted stocks from our trading universe that exhibit recognizable patterns. Once we identify such patterns, we will delve deeper into each stock, trying to decode the pattern and understand it better. Here’s an example:
- We have to see how reliable the pattern is. For instance, if we spot a head and shoulders pattern, we will examine the symmetry and proportion of the shoulders and head to determine the pattern’s reliability.
- The prior trend is crucial for any pattern. For a bullish pattern to be valid, the preceding trend should be downward. Conversely, for a bearish pattern to hold, the preceding trend should be upward.
- If all these are in place, we can analyze the chart further.
- Another critical factor to look at is the volume. It should be at least higher than the 10-day average. This confirms that the stock or index has strong momentum. Realize that for large caps, it is unusual to spot a stock trading at 2X of its average on a good trading day, whereas it is common for mid-caps and small caps to trade at even 3X to 5X of their average volumes on good trading days.
- If both the candlestick pattern and volume confirm the trade, we then check the support level for a long trade and the resistance level for a short trade.
- These levels should align as closely as possible with the stop-loss defined by the candlestick pattern. If the support or resistance level is more than 5% away from the stop-loss, we would be hesitant to continue evaluating that chart and rather move on to the next one.
- If steps 1 to 6 are satisfactory, we will calculate the risk-to-reward ratio (RRR). To calculate the RRR, we would first establish the target by plotting the support/resistance level or by defining the target depending on the candlestick or chart pattern we decided to trade on. The minimum risk-to-reward ratio should be at least 1.5.
- Finally, we look at some indicators to get a confirmation for the trade. It is good to look at moving averages and the RSI indicator.
Sometimes, we may not find any stocks that pass our checklist. In such cases, avoiding trading on those days is the best course of action. Remember, not making a loss is also a form of profit.
After placing a trade, you should wait until the target is reached or the stop-loss is triggered. It’s an excellent practice to trail our stop-loss as the trade progresses. We should avoid making changes if the trade meets all our checklist criteria. Trusting the well-planned trade increases the likelihood of success, so it’s essential to remain patient and confident.
Managing your trades
After successfully entering a trade, the next crucial step is to manage our trades while holding our positions effectively. This involves three key components: risk management, capital deployment, and trailing our stop loss. Let’s delve into these aspects to ensure a well-rounded trading strategy.
Risk management
Firstly, we must decide how much capital we will risk per trade. This depends on our risk tolerance. A good way to quantify the risk tolerance is by deciding the total amount we will lose per trade. Assuming our risk tolerance is 1%-2%, if we are trading with a capital of ₹1,00,000, we should be comfortable losing ₹1,000 to ₹2,000 in a single trade. Setting up the stop loss is crucial, and we should use our technical analysis concepts. We can determine the stop loss using support and resistance levels, the Central Pivot Range (CPR), or any method that suits us best.
Secondly, let’s look at position sizing, i.e., how much capital should be deployed for each trade. This helps to identify the number of shares or contracts to buy or sell so that you can manage risk and maximize potential returns.
Here’s a good formula:
Position Size = (Account Equity * Risk Percentage) / (Entry Price – Stop Loss Price)
where,
– Account Equity: The total amount of money you have in your trading account
– Risk Percentage: The small portion of your money you are willing to lose on one trade (usually 1-2%)
– Entry Price: The price at which you buy the stock
– Stop Loss Price: The price at which you will sell the stock to prevent further losses
Here is a simple example.
Assume we decide to buy shares of Reliance Industries. The current price (Entry Price) is ₹2,000 per share, and based on technical analysis, we set our stop loss at ₹1,950 (Stop Loss Price) to limit our potential loss to ₹50 per share.
Using the position sizing formula:
Position Size= (AccountEquity * Risk Percentage) / (Entry Price − Stop Loss Price)
Position size = (1,00,000 * 0.02) / (2,000−1,950)
Position size = 1,00,000 * 0.02) / (2,000 – 1,950)
Position size= 2,000 / 50
Position size= 40
So, we should buy 40 shares of Reliance Industries. If the stock hits our stop loss price of ₹1,950, we will lose only ₹2,000, which is within our risk tolerance.
Thirdly, we need to set a target based on the risk-to-reward ratio. A common practice is to ensure a ratio of at least 1.5:1. For every Rs 1 we risk, there should be a potential reward of 1.5.
Capital deployment
The next step is to focus on capital deployment. Proper capital deployment is essential to avoid putting too much money into one trade. Let’s look at how to use our capital effectively to make the most profit while keeping risks low.
Recall the famous saying by stock market king Warren Buffett,
In quote box – “Don’t put all your eggs in one basket.”
When we are trading, it is very important to keep focus on a manageable number of trades.
Imagine you’re a juggler. If you juggle too many balls, you’ll likely drop some. The same goes for trading. The key is to find a balance between having enough trades to diversify but not so many that you can’t keep up.
Start with just 1-2 trades at a time. As they become manageable, you can expand to 3-4 stocks. This will allow you to stay updated on each stock’s movements without feeling overwhelmed.
By focusing on fewer stocks, you can closely monitor news, earnings reports, and price movements. This allows you to make quick decisions because you know your stocks well. Additionally, tracking fewer stocks reduces stress and minimizes the chances of making mistakes.
In the morning, check pre-market news and identify any major events that might affect your stocks. During the day, monitor price movements and trading volumes. In the evening, review the day’s performance, update your trading journal, and adjust your strategy if needed.
Another effective way to manage our capital is by deploying it in phases rather than simultaneously entering a trade with the entire set capital.
For example, if trading with a capital of ₹1,00,000, we might initially deploy ₹75,000. If the trade continues to go our way, we can add another ₹10,000 and another ₹15,000, incrementally increasing our position based on our risk tolerance and trade confidence. This approach allows us to manage risk more effectively than going all-in with a single trade.
Although the profit on our total capital deployed in the trade may be lower, we are ensuring that capital is not making a loss, at the least.
Trailing stop losses
You must be familiar with the stop loss concept, which helps limit our losses if the stock price goes down. However, sometimes, a trade goes in our favor for a while before reversing and hitting our stop loss. To avoid this, it is better to use a trailing stop loss. This means adjusting our stop loss level upward as the stock price rises. We can’t do that randomly though. Strategically, here are five ways of how it can be done:
- A standard method is to set a trailing stop loss at a certain percentage below the highest price reached (for long trades) or above the lowest price reached (for short trades). For example, if you had set a 5% stop loss rule when you entered at ₹100, the stop loss would be at ₹95. If the price goes to ₹105, the new stop loss would be 5% below ₹105, which is at ₹99.75.
- You can also effectively implement trailing stop losses using the Average True Range (ATR). The ATR helps measure market volatility, and you can set a trailing stop at a multiple of the ATR value from the current price. A quick recap on using the ATR indicator might help.
- Another method is to use moving averages as a dynamic stop loss level. By trailing the stop loss at the 20-day moving average, for example, you can follow the stock’s trend while allowing for normal price fluctuations. Both methods provide a systematic approach to protecting your profits and managing risk as the trade moves in your favor.
- You can also move your stop loss to crucial support or resistance levels as the trade progresses. For instance, the Central Pivot Range (CPR) can help identify significant price levels where the stock may find support or resistance.
- Fibonacci levels are also helpful in setting trailing stop losses, as they indicate potential reversal points based on the stock’s recent price movements. By adjusting your stop loss to these critical levels, you can better protect your profits and allow the trade to develop within the market’s natural fluctuations.
Fibonacci levels
These are key price points on a stock chart that indicate where the price might reverse or pause. These levels are based on a mathematical sequence and are used to identify potential support and resistance areas.
Nifty 500 has various stocks from all the sectors IT, financial services etc.,
Summary
- Determine your trading style based on time commitment and financial goals, choosing time frames that align with your objectives.
- For swing trading, use a lookback period of 6 months to 1 year; for scalping, focus on the last five days; and for drawing support and resistance levels, use at least two years.
- Focus on a manageable set of stocks, ensuring they are liquid and in the ‘EQ’ segment; stick to Nifty 500 for simplicity and reliability.
- Risk 1% to 2% of capital per trade and ensure a Risk-to-Reward Ratio (RRR) of at least 1.5:1.
- Diversify across multiple stocks, use a phased entry style to manage risk effectively, and avoid putting all capital into a single trade.
- Adjust the stop loss upwards as the stock price rises using ATR or moving averages to dynamically trail the stop loss. Set stop losses at critical support or resistance levels to protect profits.
- Look for recognizable patterns and confirm with volume. Ensure that patterns align with prior trends. Check support and resistance levels relative to the stop loss. Calculate and confirm RRR before entering the trade.
- Place trades based on the checklist criteria, avoid making changes once the trade is placed and remain patient and confident in your well-planned trades.
- If no stocks pass the checklist, avoid trading that day and recognize that preventing losses is also a form of profit.