Saturday, April 04, 2015

Why I take signals on an intra-day basis

I had an interesting conversation this week with a trader about the merits of taking entry signals on an intra-day basis compared to an end of day basis when trading breakouts. Below I will try and explain the reasons why I take intra-day signals.

By taking end of day signals, traders are looking for a close above the prior resistance or level before initiating a position on the next day's open. They are looking to avoid getting caught in breakouts that fail on the same day, and that's all well and good. However, depending on how you calculate your position size, this could adversely affect your performance. Let me explain.

Lots of traders use a volatility measurement to help calculate their initial stop distance, and consequently their position size. In my case, I use 2 x the average true range for the last 20 days to help calculate this. And as I trade a fixed percentage of my cash equity on each trade, this measurement helps me determine my position size. The lower the volatility measurement, the bigger the position size, and vice versa.

One of the characteristics I look for in a potential set up is a contraction in volatility. Hopefully, after I enter on a breakout, then volatility will expand in the direction I am looking to trade.

Therefore, by concentrating on these set ups, in theory my initial stop placement will be closer to the price entry level, and therefore my position size will be larger.

Using this, I look to enter on an intra-day basis as soon as that price entry level is breached.  This is the method that Richard Dennis and the Turtle traders used. To me, it doesn't matter if this is in the first 5 minutes of a trading session, or the last 5 minutes. If price breaks out, then I want to be getting into the trade.

Of course, by doing this, you have increased the chances of suffering from whipsaws, as there may well be traders looking to take the opposite side of my trade at those levels. This is on the theory that most breakouts fail, and that a prior resistance level will continue to act as resistance (methods such as Turtle Soup were developed along these lines). This is what the end of day traders try to avoid.

The problem for an end of day trader comes when there is a strong price move away from the breakout level on the same day. By delaying their entry until the following day, the chances are that any volatility measurement used for position sizing purposes will also have increased.

This will mean that your position size will need to be reduced so that you still only risk the same percentage of your equity. But this has a knock-on effect on the potential risk and reward on the trade.

As an example, say that you are an end of day trader, and you watching a $10 stock, which has a 2ATR reading of 50c. This measurement is then used as your initial stop distance, thereby helping you to quantify both your position size and where price would need to fall to before triggering a full 1R loss.

Now, suppose that the stock breaks out strongly and closes well above that trigger level. So, you look to enter on the next day's open. The problem is, the 2ATR measurement has now increased to say 60c, so you need to recalculate and reduce your position size. As a result, not only are you trading smaller, price now has to move further for your position to achieve a profit of 1R, and the same again for each additional profit unit of R.

That may not sound like much of a change, but on a big enough sample of trades, the compounding effect will quickly add up.

In some cases, this creates a separate dilemma - if price really accelerates away from the breakout level, are you now chasing the trade? You may even have to consider whether you pass on the trade. And, if price gaps up on the next day's open, then this makes the problem even worse.

You may also end up with a situation where, after waiting until the next market open, your initial stop (when based on a volatility measurement) may end up being placed above the resistance or breakout level you were originally using as your entry trigger.

I always advise ensuring that your initial stop is below the original breakout level. In a lot of cases, price may retreat back and 'test' that level - this is where a prior resistance level would hopefully now act as support. If price does fall back to test that level, and your initial stop is above it, then you would get stopped out for a full 1R loss! So to get round that you would have to increase the initial stop distance even further, completely eroding your position size, with the result that price would have to move even more distance just to get to a 1R profit. It is for this reason I avoid trading stocks which gap up through my intended entry level.

To summarise, by delaying the entry, the potential is there for your position size needing to be reduced, with initial stops having to be placed further away. This adversely affects the potential risk:reward on a trade, and consequently the overall expectancy of your approach.

It is for these reasons that I am prepared to deal with the occasional whipsaw, knowing that, by entering as soon as the trigger level is breached, I am getting into a possible new trend as early as possible, on an intra-day basis. I am therefore able to maximise my position size while staying within my risk control parameters.

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