The essence of trading is a mix of three steps that any investor has to understand and find his sweet spot on. It is about when to make the first move and deciding on what price to make his investment. The second step is about where to set up his expectation or fixing the point at which to book his profits. Finally, should things not go as per plan, resolving on a price at which he should prevent further losses.
In short, a smart trader’s strategy should be a summation of determining the right entry, target and stop loss prices to optimise on the profits from the trade and also keep any potential losses to the bare minimum.
As an astute trader who wants to get this triangle of entry, target and stop loss prices right, it will help to understand these crucial principles and how they work in the real world of trading.
Determining Entry, Target and Stop Loss prices
This is an investor’s first point of contact with an investment in which he sees some scope for appreciation and returns. The entry price is the numerical equivalent of the amount of trust he places in an acquisition he plans to make.
As it is the threshold of a longer relationship he will have with that investment, the decision of whether he should enter it will be an important one. The responsibility of this decision will have ramifications as this leads to a subsequent one where he has to set the deadline for divesting it.
In the world of investments and trading, the equivalent will be identifying the right time or the price at which you make your investment. As the first step is to find the right asset or the specific instrument to buy, once that is decided, it is about finding the best price at which to acquire it.
At this stage, it is important to let thorough research, technicals and fundamentals to get you to this point. Allowing emotions to sway you can be risky unless you are a seasoned investor or trader and know you can trust your instinct. But it is better to have a proven strategy after studying the market conditions, the industry and the specific item to commit to the optimal entry price.
There are tried and tested methodologies for finding the right entry price. Here is a look at how it works in the real world.
Based on your analysis, identify the levels at which the price begins to move up and the potential for upside it has. This assessment can be based on the outcome from methodologies like support and resistance, demand and supply or techniques like the Fibonacci strategy.
Once the target price has been mapped, the current price can indicate the possible profit that can be made at that level. Buying it at a higher price than the current level but lesser than the target will result in lesser profits. But waiting for the price to drop from the current level and then picking it up can increase the returns. Also, the lower the purchase price, the lesser will be the risk potential.
So, getting the entry point right has the twin benefits of a higher profit margin and minimal risk, besides increasing the chances of success in that trade.
Now that you have done the investment at the best price possible, the logical next step is to exit it at the right time. This is identifying the highest point of appreciation at which you can exit with the highest returns possible. The secret here is to know your target price well enough.
All exits happen through one of two outcomes – getting a profit or incurring a loss. While we will come to the loss in the next point, let us get to the more positive outcome first.
Every trade that is entered into is, primarily, with the objective of making a profit. This profit, in simple terms, is the difference between the appreciation and the purchase price or the price at the point of investment. The point to which an investment can offer returns is the target set while making the entry.
Identifying the target price is the result of the analysis based on the technical and fundamentals of the investment planned. It is also the result of studying the track record of price movement.
Once you fix a target price, there is the possibility of waiting till the price hits the target and you make a100% of the planned profits. It is also possible to sell a part of the purchase at that point and defer the balance to expect higher gains or even minimise the risk, should there be a fall in the price. If the anticipated target price looks unattainable, it could be beneficial to book profits even if the appreciation falls short of the target.
All trades may not end with a favourable outcome and would demand that you have a Plan B. In trading, when your call fails to hit the mark, for whatever reason, the next best thing would be to curtail your losses.
This is what the strategy of stop loss is all about. This planning should happen right at the point of deciding on an investment and fixing the target and entry prices. Based on your analysis find the point at which there is support below the current or the entry price.
Whether he likes it or not, an investor has to draw the line below which he will not allow his investment to dip. The challenge here that most beginners and even experienced traders face is the non-adherence to this stop loss price they themselves set. Seeing their investment not just miss the planned target but also slip below the entry price can be frustrating and tempt them to hold on without exiting.
If he makes the mistake of holding on by hoping for a rebound, he runs a big risk. A recovery may happen but, in the event of the price tanking, the investment can end in huge losses too which could have been curtailed with the stop loss strategy.
For any trader planning to make a move in the market, this price trio of entry, target and stop loss are the concepts that he has to understand and execute well. The three price points of the entry price, the target price and the stop loss price are the tools that help you calculate the risk to reward ratio. To ensure that the focus is on maximising the rewards and minimising the risk, any investment needs to be done with these three points covered.