The main focus of a trader should be to understand exactly how to enter in a trade and, more specifically, when enter in a trade.
Timing and precision are fundamental for a long-term success in financial markets. A good strategy is characterised by the presence of specific and clear methods for enter in the market: you can study thousands of patterns and indicators, but if you don’t establish a precise entry way, you will inevitably loss.
We call these methods as entry filters. We use them as triggers in order to understand if a reversal or a breakout has occurred in the market; they provide us with a confirmation signal, and help us to avoid false reversal or breakouts. Therefore, they are fundamental in order to limit the probabilities of register a loss, increasing the accuracy of our entries in the market.
When to Enter a Trade: the Issue of Subjectivity
Technical analysis is not an exact science. It involves a certain degree of subjectivity that must be taken into account. In particular, Price action analysis involves a qualitative analysis (not programmable using algorithmic trading systems) of charts and price behaviour. Let’s consider the example here below:
Is this a valid breakout or not? The answer is subjective, and depends on which entry filter you have set for your trading: do you want to enter a trade just when a candle close below (or above) a certain threshold, or do you want to expect for an additional confirmation? The answer determine if you consider this condition as a true breakout or not.
Following the previous example:
We can notice that price filter employed makes the difference between a loss and a profit. When to enter a trade is fundamental: in the first case traders registered a loss; in an opposite way, traders waiting for an additional price action confirmation made a profit. In this latter case, the entry trigger is formed by a close below the one of breakout’s candle).
How to Enter a Trade: Types of Entry Filters
Mark Andrew Lim in his book “The Handbook of Technical Analysis” made an excellent work of classification about the different entry filters that can be used to understand when to enter a trade in forex or stock markets.
There are three main different types of entry filter that we can use to decide whether or not enter in a new order in the market:
- Price based filters – they indicate the exact price of entry, but not when an entry will be initiated;
- Time based filters – they indicate the exact time of entry, but not the price at which an entry will be initiated;
- Event based filters – they don’t indicate the exact price nor the exact time of entry, until an event as occurred. This is the case of a closing price violation (the method used to identify a valid breakout in the example above).
Even if on one side the possibility to use multiple approaches it’s a good opportunity to experimentation, on the other side we must notice that this fragmentation contributes to increase the degree of subjectivity connected to this practice.
Let’s now consider each type of filter more in detail.
Price-based Entry Filters
Price-based entry filters are further divided in the following categories, according to M. A. Lim:
- Absolute measures
- Fixed-price excursion
- Relative Measures
- Percentage of breakout price
- Volatility Measures
- Multiples of ATR (average true range)
- Multiples of standard deviation
Let’s consider the example here below concerning the Gold market, daily chart:
We can see that in two cases price experienced a false breakout before to actually break the support level identified. Thus, we can say that when to enter a trade is important as the overall decision to buy or sell a specific financial instrument. By adding the most appropriate entry filter, we can reduce the number of losses by picking just the best trades in the market.
Personally, I don’t like price-based entry filters, since I like to wait for additional price action confirmation. Let’s now move forward considering time-based entry filters.
Time-based Entry Filters
Classification for time-based entry filters is much easier. These kind of filters are based on the duration of N-closed bars after a breakout. For example, we can decide to enter in a trade 3 candles after the one who broke the validation level.
Look at the example below, concerning the same condition seen before:
In this case, we can see that the entry is more conservative. We decide to wait for additional confirmation coming from price action subsequent to the breakout.
Nevertheless, even in this case most of the job depends on the value set for filtering out false breakouts. Should we wait for 3 candles or more? There isn’t a common answer, the best we can do is to test past price action, making a statistical analysis about which filter is the best (see the last paragraph about backtesting).
Even-based Entry Filter
Finally here we are! Event-based entry filter are the best method, at least for me, if you want to know how to enter a trade in forex or stock markets. Mainly, there are two types of those filters:
- Closing Price Violation
- Barrier retest after a confirmed breakout
Personally, I’ve decided to employe these kind of filters in my everyday trading for the following reasons. First, they are by far the most used methods and the more an indicator/ a setup is traded, the more it is valid; Second, for a psychological matter. I’m more comfortable in enter a new trade after a strong price confirmation like a price retest of the level invalidated.
So, using the same example in Gold market, we can observe the following condition:
I hope you’ve seen the third main reason why I prefer event-based entry filters and in particular the barrier retest after a valid breakout.
This last method, grant you the possibility to enhance dramatically your risk-to-reward ratio! Indeed, by trading a set-up like this we are able to enter in the direction of the market on a more advantageous point. Moreover, we know that support and resistance barriers act as magnets for price action, an additional reason why we should expect price to retrace in the opposite direction at least one time before to continue into its main direction.
How to Enter a Trade: the Importance of Backtesting
In technical analysis we cannot simply guess which is the best entry filter for our trading strategy. We must study the past to add odds to our trading activity. We can do that thanks to the backtesting: we look at past price data, we analyse how price behaved in the past and we drive our conclusions.
Let’s support that our trading strategy consist in trade a channel breakout; we want to set a time-based entry filter to spot valid breakouts in the market. All we have to do is to look at the past, searching for all the setups that satisfy the conditions set in our trading plan. At this point, we should observe how price behaved, by setting the most appropriate entry filter.
Backtesting it’s something so important and fundamental for each trader who wants to be profitable that deserves a specific article apart. I advise you to inform yourself about this practice, since it constitute probably the most important step towards a sustainable success.
So Far So Good, but Avoid Over-optimisations!
Nobody says that you can’t use more than one filter to set a precise entry in the market. Nevertheless, I advise you to pay attention about the threat of over-optimisation. Filtering out price action help us to reduce the number of false breakouts we enter into, contributing to cut the losses registered.
However we must not exaggerate with the filtering process. If we add too many filters, trying to create the perfect one, we risk to filter out nearly all the opportunities in the market. This can result in a condition in which we are not able to enter in any trade, even the profitable ones.
Remember: the perfect entry filter, simply doesn’t not exists. “Technical analysis deals with probabilities, never certainty” according to Martin Pring in “Technical Analysis Explained“. We must bear in mind that loses are physiological while trading online. For that reason, our goal is to find the entry filter which best fits to us and to our trading strategy, and not the perfect one.