This appears to be superfluous if you have read my article last time in connection with the studies cited on the comparative importance of the two components of the trading equation, namely: the entry or buy side, on one end, and the exit or sell side, on the other end. In the studies made, how these two components are handled determines the outcome of profit or loss made in one’s trade.  

The results of the studies all came to the conclusion that entry or market timing is not critically as important as exit. Success and failure of one’s trade depended more on when to sell. Those who made the studies also claimed that taking a position in the market can be as good as anytime, like by random entry. This was possible due to the mean-revertive character of the market.

Mean reversion, as they say, isa financial theory which postulates “that asset prices and historical returns eventually revert to their long-term mean or average level.”  

One of those who made a good deal of study on the matter is Van K. Tharp, whose story was that he lost all his account twice when he was starting to trade and who subsequently became the author of four acclaimed books, one of which is Trade Your Way to Financial Freedom. Tharp strongly attested that “Entry only plays a small part of the game of making money in the market.” 

Begging the question

Yet, efforts in finding ways to improve entry techniques cannot be neglected. Investors still have to watch out for the need “to minimize investment risk and remove the play of emotions” in the act of entry. Thus, while entry may not be essentially as important as exit, it remains to have a good role to make in the trading equation. Tharp has a nice term to it.  He calls it as “trading to beat random entry.”

For example, even experienced investors are stopped out of a good trading idea just because they entered early. The way the market has been moving in the last two months, I’m sure this has happened and continues to happen to many of us. We may have abandoned or thinking of abandoning a good stock pick because the direction of its market price is just unclear as of late.

We are also stopped out sometimes in our eagerness to enter too soon because of the “fear of missing out” or what is called FOMO in the market. This is a classic example of allowing emotional decisions to play in one’s entry.  

These are the common problems faced by beginners. However, these are also situations that are not uncommon to hound experienced investors.  

Just on these two examples, I believe they are good enough to serve as a sufficient basis to assume why a good entry still matters.  

Before we leave the subject, however, let me reiterate that even the proponents of good entry admit that the following are more contributory to a successful trade. These are exit strategy, risk management, and position sizing, to mention the three most critical factors.

We are told that there are only two reasons you should get out or exit a trade. These are when you take a loss or when you take a profit.  

There are many books available on these two subject matters. But let me add that in taking a loss, you may just go back to the recovery risk table I presented in my article on March 10. The said table shows the exponential return you need to recover.  It also shows you the level of loss you can reasonably play before you need to fold.  

Based on the table, you should not incur a loss of more than 20%. Otherwise, you’ll be like Tharp when he first started to trade.  

In taking a profit, there are qualitative and quantitative methods recommended. We’ll explore them sometime.   

Position sizing

Risk management is about “minimizing potential losses without sacrificing upside potential.” The principle behind it is based on analyzing the expected returns of an investment compared to the amount of risk taken on to earn those returns. This is a subject Tharp sufficiently addressed in his book in what he calls the R Multiple – a form of measurement of risk versus reward. To illustrate, if you buy a stock for P10 (risk) and sell it for P15 (reward) your R would be (P15 – P10) divided by P10] is equal to 0.5 or 50%.  Thus, enter a trade only where the R is high.

Position sizing is referred to as the method of determining the size of the shareholdings to be held by an investor. It is also referred to as the amount of money being traded in a given stock or asset.  Its application will help investors earn maximum returns and at minimal risk.

For proper position sizing, there are three factors to be properly weighed.  First is the account risk.  Typically, account risk is expressed as a percentage of the investor’s total capital.  As a rule of thumb, individual investors should not risk more than 2% of their investment capital on any given trade.  (Fund managers risk less than this amount.) With a P500k total capital, the investor is limited to risk P10k per trade only. The rationale behind this is that even if the investor loses 10 consecutive trades in a row, the impact is equivalent to only 20% of investment capital.  

Next is the trade risk. This involves determining where to place the stop-loss order for the specific trade.  For example, if an investor intends to buy SMC at P105 and place a stop-loss order at P185, the trade risk is P20 per share.

To derive the proper position size of the above information, divide the account risk of P10k per trade and the trade risk of P20 per share. This means the investor should only buy 500 shares (P10k/ P20) of SMC to achieve maximum returns at minimal risk.

So, what is a good entry point? We’ll take up this question next time as we analyze what is happening in the market as we usually do.  We devoted the whole article today just to raise the point that entry is an important part of the trading cycle, too.

Don’t miss the discussion on the different methods and/or techniques for finding good entry points. It will be next. – Rappler.com

(The article has been prepared for general circulation for the reading public and must not be construed as an offer, or solicitation of an offer to buy or sell any securities or financial instruments whether referred to herein or otherwise.  Moreover, the public should be aware that the writer or any investing parties mentioned in the column may have a conflict of interest that could affect the objectivity of their reported or mentioned investment activity.  You may reach “Thin Slicing” at densomera@yahoo.com.)