[Disclaimer: all the information in this series of articles is for educational purposes only. The author do not claim or guarantee that the readers may benefit from the information provided.]
Initial Entry
The time to enter the market is to buy at the exact moment when the price reaches a brand new high. One may do this with the help of a stop-limit order. For those who have no idea, a buy stop order means the broker shall only purchase a security only when the price goes above a certain level (the “stop” level) as long as it remains within a threshold (the “limit” level). To be precise, he shall a set buy stop-limit order with the stop at 1 % above the high and the limit 5% above.
In the last example of a hypothetical equity, the current all-time high was $42.00. In this case, one shall only purchase it at $42.50, roughly one percent above $42, as long as it does not slip above $44.10 (105% of $42). Therefore, one shall use a stop-limit order of $42.50-$44.10 to catch the breakout.
Stop Loss
Investing is a game of probability in which there is no sure way of winning. If there were, the market would cease to exist. Therefore, one shall always go into a trade with the mindset that there is always a chance that a trade will go against him. To ensure against this, he has to attach a stop loss order at the same time of the entry, as it enforces the discipline to get out of a losing position no matter how much one believes that he is right.
One shall set the stop loss level at eight percent below the entry level. In the above example, the buy stop is at $42.50, so the stop loss should be at $39.10, or ninety-two percent of the purchase price. In practice, this stop level may have to be adjusted after the market fills the order, because one may buy at a price higher than planned due to slippage. If it happens, one shall change the stop level so that it remains 8% below the actual purchase price.
One shall set the stop loss level at eight percent below the entry level. In the above example, the buy stop is at $42.50, so the stop loss should be at $39.10, or ninety-two percent of the purchase price. In practice, this stop level may have to be adjusted after the market fills the order, because one may buy at a price higher than planned due to slippage. If it happens, one shall change the stop level so that it remains 8% below the actual purchase price.
Sizing
After knowing when to get into a position, the next question is how much to get into it. As a rule, one shall not risk more than two percent of the trading capital during the first exploratory entry. Since the maximum movement which one is willing to risk before taking a loss is 8%, it follows that the operator shall only adopt a position size of a quarter of his capital if he wants to contain the maximum damage to 2% of his total trading account. For example, if the account size is $10,000, then he shall only buy $2,500 worth of shares in his position.
To calculate the number of shares which he shall buy, he simply has to divide the allocated capital by the entry price. In the examples mentioned above, the entry price was $42.50 and the position value is $2,500. By dividing $2,500 with $42.50, he will know that he shall buy fifty-eight shares.
To calculate the number of shares which he shall buy, he simply has to divide the allocated capital by the entry price. In the examples mentioned above, the entry price was $42.50 and the position value is $2,500. By dividing $2,500 with $42.50, he will know that he shall buy fifty-eight shares.
Gapping Up
Sometimes, the market does not go up and down in a continuous fashion. If the demand for the equity is enormous, the price may open at a higher level than the previous day’s high and go on to advance further without coming back to tough the last high. This situation is known as a gap-up.
If the share price does gap above the breakout level by at least 5% and does not look back, one shall examine the following to see if the breakout is still buyable. Firstly, the trading volume of the first hour must be at least half as the fifty-day average value. It ensures that there is significant demand behind the move. Secondly, buying on gap is much more reliable if it happens within the first three years of a bull market. Beyond this window, it is usually a sign of exhaustion rather than strength.
If it fulfils the above two criteria, then use the following rules to manage the position. Instead of the usual 8% stop loss, increase it to 12%. Also, only trade one-sixth of your account size instead of the standard one-fourth. This decrease trading size and greater stop loss distance are to offset the increased volatility of the gap-up.
Summary
In summary, here is a list of rules for entry and sizing:
1. Use a stop-limit order. Buy at 1%-5% above the three-year high.
2. Always set a 8% stop loss below the actual entry.
3. In the case of a gap-up, use a 12% stop instead.
4. Risk 2% in the first entry.
Click here for Part 3.
If the share price does gap above the breakout level by at least 5% and does not look back, one shall examine the following to see if the breakout is still buyable. Firstly, the trading volume of the first hour must be at least half as the fifty-day average value. It ensures that there is significant demand behind the move. Secondly, buying on gap is much more reliable if it happens within the first three years of a bull market. Beyond this window, it is usually a sign of exhaustion rather than strength.
If it fulfils the above two criteria, then use the following rules to manage the position. Instead of the usual 8% stop loss, increase it to 12%. Also, only trade one-sixth of your account size instead of the standard one-fourth. This decrease trading size and greater stop loss distance are to offset the increased volatility of the gap-up.
Summary
In summary, here is a list of rules for entry and sizing:
1. Use a stop-limit order. Buy at 1%-5% above the three-year high.
2. Always set a 8% stop loss below the actual entry.
3. In the case of a gap-up, use a 12% stop instead.
4. Risk 2% in the first entry.
Click here for Part 3.
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