. While you wait for your copy of the book to arrive, you can read my post on how many shares to purchase as well as The Real Time Trader's take on the same subject. There is no substitute for Tharp's book, however. It has been the most important book on trading I've ever read.
This post will cover the purpose of my system, my trading concept, what my setups are, how to read the table with the Entries and Exits, how to choose between the Aggressive and Conservative exits, how and when to place buy and sell orders, what to do if price is above the Entry or below the Exit prices, and how many positions you should own. The subject of when to sell is the subject of my post on exit strategy.
My stock trading system is the system I use to make money in the stock market. The #1 goal of my system is capital preservation. The #2 goal is to make a steady income. The #3 (and by far least important) goal is to hit the jackpot on a few trades. I strongly believe these should be your goals as well, and in that order.
The theoretical basis for my trading concept is Elliott Wave theory, which in turn is based on the theory that prices trend. My system trades equities on the US markets that are more likely than not to experience price increases in the coming days. Three common setups I look for are small pullbacks in a strong uptrend, lengthy consolidations, and reversals in a downtrend. This list of setups also happens to be ranked in terms of likelihood of success!
The cornerstone of each setup is an entry and an exit. The entry price indicates the minimum price level at which the stock must trade before we buy it. We are not trying to buy at the bottom here — leave that to the daredevils who don't care about preserving capital. I expect that a large percentage of the trade ideas I generate will not make it to the entry price; because we are not involved, these end up being failed signals rather than losses. Do not buy the stock unless it is trading at a price equal to or greater than the Entry price! I have no power to predict where stocks will go. I can only identify promising setups, but even then I need evidence that the stock can deliver on that promise. This evidence comes in the form of positive price action — if the stock price can breach the entry level, that proves to me that there is demand and potentially momentum for that ticker.
While the Entry price is straightforward, you might have noticed that there are two Exit columns for the signals. Exit A indicates the Aggressive exit, and Exit C the Conservative. In fact, the tables describe two slightly different trading systems. The Aggressive system is optimal for trending bull markets, while I use the Conservative system in weakly trending bull markets and bear markets. Neither of these systems does well in non-trending markets. For that, you will have to look elsewhere, such as a day-trading system. So whether you choose to use Exit A (Aggressive system) or Exit C (Conservative system) depends on market conditions — but it also depends on you. In a strongly trending market, one makes more money with the Aggressive system, and at the same time one doesn't get stopped out that often. However getting stopped out early is unavoidable; that's just the price one pays for being able to buy more shares for the same dollar risk. That means you have to be OK with getting whipsawed more frequently using the Aggressive system no matter what, as stocks will go below the sell-stop price, forcing you to sell, and then rebound to new heights - without you. This is less likely to happen when using the Conservative exit because the latter price level represents a more key level of support. While I've gotten whipsawed in a matter of minutes using the Aggressive system, the fastest I've ever gotten whipsawed using the Conservative system was 4 days.
There are other trade-offs involved. One big downside for the Conservative system is that for the same amount of risk, you can't buy as many shares. For example, given the following trade idea:
| Ticker | Entry | Exit A | Exit C |
|---|---|---|---|
| ABC | 3.36 | 3.23 | 3.07 |
To buy stocks in my system, I recommend you use stop-limit buy orders through your broker. Note that you are buying stocks as they are moving up (buying on strength). A stop-limit order consists of two numbers: a trigger price and a limit price. The trigger price is the minimum price at which the stock will trade (or be bidded/asked - see What To Look For in a Brokerage for a discussion on these variations) before an order to buy the stock at the limit price is executed. The advantage of stop-limit over a plain stop order (a.k.a stop-market order, which becomes a market order upon hitting trigger price) is that you put a cap on the price you will pay for the stock. This is especially important for stocks that have wide bid/ask spreads. For example Mastercard (MA) routinely has bid-ask spreads of 50 cents. A buy stop order at 237 might execute at 237.50. If instead you used an order of buy limit 237.25 stop 237, the maximum you'd pay is 237.25 per share. The downside is that if price action is very strong, your order may not get filled as the market price jumps right over your limit price. For example MA could gap from 237 to 237.40 and then keep going, leaving you with no shares to show for your effort. Make sure that you leave enough room between the stop price and the limit price so this doesn't happen often.
Once your buy order executes, place a sell stop-limit order to protect your capital. Use the figures in the Exit column as your guide. As the position goes higher, I will adjust the sell-stop upward, thus locking in profits. Make sure there is a sell stop-limit order in force each day you carry the position. The point of all of this is that if the stock is trading at or below your exit price, you need to exit the stock. Remember: the #1 goal is to preserve capital. It is not to make money, it is not to make a ton of money, it is to keep what money you already have. That's why it is imperative that you sell your position if it goes below your sell price. I recommend that you enter your buy and sell orders after the market has opened and definitely after the stock has traded a few times (assuming you have access to that data). This is so because sometimes the first trades of the day are not in line with the market, and market makers have the leeway to make questionable calls that may result in unexpected losses for you.
What should you do if the stock price is greater than the entry price, and you're not in it yet? Should you buy? There is no easy answer to this question, and it's also not an uncommon occurrence. It's really a judgment call. You can always forget about it and focus on other ideas. If you decide to buy it, I advise you to buy fewer shares. Use the calculations in How Many Shares to Buy using the new entry price and consider risking a smaller percentage. You can also wait to see how the stock fares and perhaps buy at a different price - maybe on a higher high, or waiting to see if it comes back to the initial Entry price. In the latter case, I recommend that you reduce your risk dramatically because you are NOT in the same position as if you had purchased the stock in the first place. You have the advantage of seeing subsequent price action - for example you now know the stock didn't continue going straight up after hitting the Entry price. You may also be buying on a short-term downtrend. The risks have increased, so you must compensate by risking less.
What should you do if the stock price goes below the level of the Exit price, and you don't own any shares yet? First, if the price is below the Exit C price, the stock idea is a non-starter, period. Strike it off the list; it is no longer valid. If the price is below the Exit A price, and you are still interested in owning the stock, then the new Exit A price is the low price of the day (or a few cents less, if you want to give yourself a little room). This may mean you need to recalculate the number of shares you buy. As always, don't buy the stock until it rises to the level of the Entry price; the only things that change as a result of this situation are the stop-loss price and the number of shares to purchase.
Finally, I wanted to cover how many positions you should have at any time. The rule of thumb is a maximum of 12 full positions. You don't want more positions than you can keep track of, and you don't want to be unduly exposed to risk. One thing I do each day before the market opens is figure what my total exposure is. For each holding I subtract the sell-stop price from the closing price, multiplying that by the number of shares I have. This gives me the amount at risk for each holding. I don't want the sum of that to be more than 6% of my portfolio, and definitely much less than that in a tough market environment. That amount represents the most I stand to lose - assuming I have the discipline to sell my holdings once they fall below the sell-stops, and also that the market doesn't nosedive the next morning.
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