Many traders focus only on one price when placing a trade. Unfortunately, the price they tend to focus on—the target—isn't even the most important price of the trade. Professionals use three prices when placing a trade. The current price (entry), the stop price, and the target price—of these three prices, the target and the stop determine the parameters of the trade. The entry is the price that determines the critical reward-to-risk ratio.
We've written previously here and here about how to choose a stop level. We wrote those articles first, because the stop price is the most important price of a trade. Knowing where on the chart you were wrong is crucial for determining what your maximum risk is. Once your stop is determined, the target price can be decided upon. Choosing a target typically involves looking for areas of potential resistance. These will usually be either a major moving average or a previous significant high or low. Once the target is determined, the "bookends"—stop and target price—of the trade are in place.
Once they are decided upon, the bookends of the trade don't move much. Sure, the stop will get raised as the trade progresses, but we think of the bookends as the fixed part of the trade. An example might be the top and bottom of a channel that the price has been trading inside of. The boundaries of the channel don't get moved, but the price fluctuates inside of the channel markers. Now, let's take a look at the variable part of the trade, the entry. The entry price is the final number needed to determine what the total potential risk, and reward, will be. Think of it this way—the farther the entry is from the stop, the greater the risk is relative to the reward. So it stands to reason that we would want to achieve as low an entry as possible to maximize reward, and minimize risk. This is evident on the chart below which shows two hypothetical setups. Notice the bookends haven't moved, but the quality of the trade changes dramatically the further we get from the stop price.
The above illustration does a good job of showing how the risk profile changes dramatically depending on the entry. It should be obvious by now that we want to enter a trade as close to the stop as possible to minimize total risk. Not only does a close stop minimize the loss per share, but it also allows us to take a larger trade size than we would otherwise be able to take if the price were further from the stop, because the loss per share is smaller when we are close.
Generally, the longer the expected timeframe for the trade, the longer term chart you can use to determine the reward-to-risk, and less important it is to catch the bottom tick. Extremely long-term buy-and-hold type traders might look for the beginning of a rally on a monthly or weekly chart. For multi-week trades, a daily chart will usually work quite well. But with shorter term trades, and especially for day trades, catching an entry that is close to the stop is crucial to getting an acceptable reward for the risk being taken, and that can often be accomplished using a shorter time frame chart.
It sometimes pays to zoom in to a 30-minute or even a shorter term chart. When entering a long trade, I prefer to enter green candles that are working their way higher over red candles that are immersed in a downtrend. But if a stock spent the first three weeks of a month declining, and then recovers in the final week, there will be a big difference in how a long-term and a short-term chart might look. On a long-term chart, it will show a big fat red candle that should be avoided. On a daily chart, it might show a green candle, but by the time it prints a swing low, it is too far from the stop to be worth attempting for a short-term trade.
When a significant level of support is being tested, there is a higher than average expectation for a bounce. Let's take a look at a chart of soybeans to see how different time frames can give a totally different look. First, a monthly chart. See the big red candle? Remember, in general we like to buy rising green candles rather than declining red candles. This is one big red candle that would suggest more downside to come.
Now let's look at the same chart, but zoom into a daily chart to see if we can see a reversal that might be worth trading. Notice on the daily chart, we can see a clean reversal at the 200-DMA, but we still don't see a swing low where the final candle rises above the high of the candle before it. When trading a bounce off of a moving average, I like to buy the green candle that is rising away from the moving average rather than the red candle that is approaching the moving average. In other words, I like to trade a setup that shows the possibility that a reversal from down to up has already occurred before entering the trade—this avoids us trying to "catch a falling knife."
On the way down, each candle will usually make a lower low, and a lower high. After it reverses, it begins to print green candles that print higher lows, and higher highs. That is the side we want to be on. In order to find a swing low, we need to zoom in a little bit further.
Now we will zoom in to a 30-minute chart to see if we can spot the swing low. Here, we can see how different the chart looks when zoomed in. Suddenly, we can see gaps, and several small changes in direction. The one we are most interested in though, is the bounce off of the 200-DMA (gold line). Notice how the price dropped to test the 200-DMA before bouncing and printing a swing low. This is the ideal point of entry, and it wasn't visible on a monthly, weekly, or even a daily chart.
The 30-minute chart above shows a clean reversal after testing the 200-DMA, but what about a shorter time frame? If we zoom in to a minute chart, we can see how things tend to get messy. Suddenly instead of a clean reversal off of the 200-DMA, we see it actually printed a double bottom that would have stopped you out had you only looked at a minute chart and bought the first swing low.
The next time you see a setup that you are interested in, experiment with different time frames to see if one of them provides a clean signal for entry. As you can see in the charts above, there will usually be a time frame that clearly shows what is happening and where an entry should be. In general, we view monthly and weekly charts just to see what the trends have been longer term, then the daily charts to find potential setups. Once we see stocks with potential, we often zoom in to a 30-minute chart to see if it is likely that we can optimize our entry price.
When zooming in, keep in mind that the shorter term the chart is, the more random the price moves tend to be. A minute chart will provide all kinds of fresh buy and sell signals that will reverse each other several times per day, and we find them to be more or less useless. Zooming out enough to see the reversal, but not so close that it provides too many false entries is key to improving our trading success.