A pattern is only as good as the price action that follows it. Many players get caught up in the hunt, thinking all it takes to trade is a good setup. Unfortunately, this approach is a great way to lose money.
Trade setups are predictive archetypes, nothing more and nothing less. Some evolve with textbook perfection, while others show no regard at all for your expert opinion.
Good trade execution is a three-step process. You find the pattern, you study how price interacts with it, and you decide whether or not to pull the trigger. A good percentage of setups never reach the moment of decision and should be discarded without a second thought. Many traders have trouble with this limitation, because they expect the markets to pay off like a racetrack, through a simple pick-and-play strategy. In other words, they take positions the same way a gambler bets on horses. But the markets don't work this way, and setups can't be treated like tipsheets.
When I post a new pattern, someone always asks when they're "supposed" to take the trade. I tell them to take it when they get a buy or sell signal. Of course, this makes things worse, because many folks don't know what signals look like. So perhaps a little instruction is in order.
The execution target defines where to buy or sell short. A good setup points to this price through support-resistance, pattern recognition and the reward-risk ratio. A couple of limitations affect execution targets, though. First, any external forces that might affect the trade opportunity must be considered as well before taking the trade. Second, the target will change dynamically as new data alter the setup. It's possible a single tick will affect the calculated reward-risk ratio and bust the intended trade entirely.
The execution zone stands between current price and the execution target. This is an attention boundary for your trade entry. You shift focus toward the execution target when price penetrates the execution zone. So where do you draw this important interface? Place it at a distance that allows adequate time to examine whether or not to take the trade when price hits the target.
Use common sense to identify useful execution zones. Look at recent volatility and measure a fixed distance from the target. Or locate the last support level your setup must pass through before reaching the execution target, and place it there.
You have three entry choices on most trade setups:
- Enter in congestion near a breakout or breakdown.
- Stand aside when the breakout or breakdown occurs, and wait for a pullback.
- Try to get in as a breakout or breakdown starts, and hope to get filled at a good price.
Each entry strategy fosters its own execution zone/execution target combination. The key is to enter long near substantial support, or sell short near substantial resistance. Of course, this is harder to do than it sounds. Emotions rise in moving markets, and the decisions we take in the heat of battle may not be the best ones for that setup. But that's part of the fun of swing trading.
Let's look at two examples.
Genesis Microchip (GNSS) had a triple-bottom short setup last week. But bad timing empties trading accounts on this volatile stock. So when was the right time to sell it short?
Genesis printed a NR7 (narrowest range bar of the last seven bars) just before collapsing into the mid-40s. This would have been an excellent place to enter, but it would have required seeing the signal just before the close, and then jumping in. The trader could also sell short the next morning when the stock gapped down, but a bad fill would place the position at risk for a reversal or short squeeze. The third method is still on the table. Genesis may still rally back to the breakdown level and present a very low-risk entry.
Manhattan Associates (MANH) also set up an interesting short sale last week, but the outcome was quite different. It sat near a double-bottom failure, but overnight news gapped up the stock. Because the failure never triggered, there was no risk from short entry choices two or three. But there was risk if a short position was entered on the prior bar, in the bottom congestion.
The good news is this narrow zone triggered an exit signal as soon as the stock gapped up above it. And the fill on a position in this quiet zone would make any loss more palatable.
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