Entry Rules specify exactly when an entry signal is generated.
"Buy when the high of the most recently finished price bar is higher than the previous bar" is an example. On a daily chart, this rule would translate to "buy when today's high is higher than yesterday's".
Note that the entry price has not been specified - that's for the next post. At the moment we are dealing with "Yes we can enter a trade" and "No we cannot" only (and maybe a direction for the trade, but sometimes the Entry Price we use does this for us. I'll explain about this more next post).
You might have a whole bunch of Entry Rules: "Buy when the today's close is above the 20-day moving average" "Buy when 20-day moving average is above the 30-day moving average"
Etcetera, getting more and more complicated.
ALL of the Entry Rules must be satisfied for a trade to be allowed. If you have the word "OR" in your system, essentially you have more than one system.
For example:
"Buy when the today's close is above the 20-day moving average"
OR "Buy when 20-day moving average is above the 30-day moving average"
That is actually two systems - one where you can buy when today's close is above the 20-day MA, and another where you can buy when the 20-day MA is above the 30-day MA.
There's no problem with this, but I'd split them out to 2 systems so you can better judge each rule's effectiveness. If you kept it as 1 system and things go wrong, how can you tell if it's the first Entry Rule that's stopped working, or the second?
The result of adding all the Entry Rules together is a simple Yes/No answer (again, and maybe a direction for the trade). Yes - we are allowed to enter the trade. No - we are not allowed.
Sounds simple, but if it is so simple, why are we sometimes in the state of "I'm not sure"?
Your system might even specify a further rule to cover this case: "when you're in doubt - don't trade". But if the Entry Rules are specified clearly, how can there be doubt? It could only be if the system was not mechanical - if there was some subjective aspect at play. Mechanical systems have rules that you, me, your neighbour's kid, would all come up with the same answer. Systems with some kind of subjectiveness often have this "if in doubt get out" clause.
Support and Resistance (SR) lines are often the culprit.
SR lines look objective at first, but they can be placed at different prices by different people. They can be placed at different prices by the same person on different days. Unless there are mechanical rules on how to determine the location of SR lines (unlikely), they are subjective.
"Divergence" of the price from a specified indicator is also rather subjective. Divergent over what time period? Divergent by how much? If the stock price goes up a lot, but the indicator goes up only a little, is that divergence?
"Only trade in the direction of the trend" is another good one. In one of the systems I bought, a rule was "the trend is defined by the 3-month chart looking at daily candles". Easy to judge if the chart starts at the bottom left and ends at the top right. But what if it goes down for 6 weeks, and then up for 6 weeks, kind of finishing flat over the 3 month period? What's that trend - flat or up? What decision would you make if all of your other rules were screaming out for a trade entry?
The next system I bought clarified this - "If the close is above the 20-bar MA, it's an up-trend. If below, it's a down-trend". And there you have why I gravitate to mechanical systems - two systems involving "the trend", one was subjective, the other objective. One leaves you in doubt when things aren't clear cut, the other makes things rather simple.
You (well, I) need a trading system that is written down somewhere. Kind of like a checklist. Exactly like a checklist. Before entering a trade, all the Entry Rules *must* be satisfied. All of them. You can't ignore Entry Rules. If you've got 10 of them, and just 1 fails, there is no trade. There is no point to have the 10th rule if you're going to ignore it. If you want to drop it then backtest your system with and without that rule. If you get better results without it, then you can remove it. But you can't remove it just because it's in the way of a trade you want to take.
Because the rules are mechanical, there will not be much thought required. You've already backtested the system and the results were good. Now just tick off each rule. One rule not satisfied is enough to prevent the trade. All ticks means you can enter.
But at what price? That's next time.
You'll need to experiment. You can come across possible rules on websites, at seminars, in books, in lots of places. The short of it is though, that you have to experiment yourself so you can be satisfied.
Here's the thing - each and every indicator is included in someone's profitable system, somewhere. Guaranteed. It doesn't actually matter too much whether you stick with simple moving average crossovers, or you want to use Bollinger Bands, or Stochastics, or whatever. There'll be a way to squeeze whatever indicator you want into a profitable system. The key, I think, is experimentation and backtesting.
Here's another thing - some people swear by trend-based systems, and others believe break-out systems work, and others think everyone else is wrong and only scalping works in today's market.
It's similar to how some people swear by stocks, and others by real estate. Actually both work, but some people are more suited to one than the other. If someone tells you why real estate is so much better than stocks, it simply means they couldn't get stocks to work for them. Maybe you can. A lot of money is made everyday in both.
And so I can guarantee that there are profits to be made using all three methods - trend-following, break-outs, and scalping. If someone says one is better it means they couldn't get the other two to work. Maybe you can.
The test for Entry Rules is done by placing arrows on the chart. How close to peaks and troughs do they signal entries?
Unfortunately, your Entry Rules will probably give you a chart filled with arrows. You'll really need to combine your Entry Rules with your proposed Entry Price in order to really get a picture on what your system would do. More on Entry Prices next time.
This page displays all currently available trading rules in our Automated Trading Machine. We're always adding more. Mix 'n' match.