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Mapping Out an Exit (and Entry) Plan

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May 1, 2014
Mapping Out an Exit (and Entry) Plan

You probably wouldn’t hop on a tour bus in a big foreign city without bringing along your handy sightseer’s guide. The same applies to the markets. Eyeballing your charts can help you identify possible entry and exit points.

Do you have an investing idea that’s based on a company’s fundamentals, but aren’t sure where to buy? Are you sitting on a profitable stock position, but don’t know where or when to pull your chips off the table? Adding some basic technical analysis tools, in conjunction with a firm grasp of the fundamentals, can help provide answers.

Technical analysis and charting theories are based in part on the theory that markets tend to move in recognizable patterns, and that those patterns often repeat themselves. Much like your tour map or GPS system, your charts may provide some guidance for the journey ahead. Let’s consider three questions:

1. How do I find potential entry points in a rising stock trend?

2. How can chart patterns offer potential entry signals?

3. When is it time to take profits on a winning position?

1. Find Entry Points

All markets display trends, but they don’t usually move in a straight line higher or lower. Markets will pause and move sideways, “correct” lower or higher, and then often regain the momentum to further the overall trend.

If you’ve identified a stock in a clear uptrend pattern, defined by a series of higher highs and higher lows, one possible technique is to look for price “pullbacks” to enter new trades. The trendline is typically viewed as technical support (or resistance, for declining markets), meaning that as long as the price doesn’t move below that line, the trend remains intact.

Watch your chart closely when pullbacks happen. The price may “test” that trendline support, but if the gates of the castle hold up, so to speak, you could be looking at a good place to add to your position.

Trading volume, or the number of stock shares that changed hands during a trading day, is used by many traders as a kind of “confirmation.” Rising prices accompanied by rising volume are typically viewed as a bullish confirmation signal. Look at the volume bars underneath the price action for clues to the strength of the trend.

Let’s take a look at how charts can help pinpoint potential entry points (figure 1).

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FIGURE 1: DRAWING FUNCTIONS AVAILABLE ON THE TRADE ARCHITECT? PLATFORM illustrate a stocks longer-term direction through trendlines, which can help identify entry and exit points for a trade. Source: TD Ameritrade. For illustrative purposes only. Past performance is no guarantee of future results.

2. Chart Pattern Entry Signals

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Another charting technique involves using “continuation patterns,” such as flags, pennants and triangles. These patterns are like little cheat sheets to help define potential entry levels and objectives, as well as where to potentially place “stop-loss” orders to attempt to limit your exposure if the market moves against you.

Remember, trending markets sometimes pause and “take a break”— imagine the bulls are tired and need to rest (or take a few profits). Such a resting period can emerge on a daily chart in the form of a pennant, a common continuation pattern. A bullish pennant pattern can help identify an upside breakout, a brief pause or congestion period (which forms the pennant), and then a thrust higher as the stock move continues.

A typical pennant pattern forms with an initial quick, strong rally move called the “flagpole.” Then the action turns sideways in a short-term consolidation, which forms the pennant. The entry trigger is a breakout higher from the pennant. Take a look at figure 2 to see how a pennant pattern can pinpoint potential entry points for a stock trade.

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FIGURE 2: A BREAKOUT FROM A CONTINUATION PATTERN ,such as a pennant, can presage further upside and help identify potential price targets to enter and exit positions. Source: TD Ameritrade. For illustrative purposes only. Past performance is no guarantee of future results.

3. When To Take Profits On A Winning Position

No one likes it when the party is over, but you don’t want to be the last one to leave. If you are holding a winning position and are considering booking some profits, the chart can once again be a helpful guide for knowing when it’s time to “call it a night.”

Trendlines don’t just offer possible entry points—they can also provide potential exit signals. If you have a successful trade going but the stock closes below trendline support, that may suggest the trend has run its course. Consider locking in any gains.

The pennant pattern can also be applied to an exit strategy. In this case, you’re looking for a price “objective,” or the target the stock would have to reach for you to exit the trade. Looking at the pennant example in figure 2, you might determine an objective by taking the length of the flagpole and adding it to the breakout point.

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