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Execution Strategy and First Class Seats
The correct strategy in the execution of a trade comes right at the bottom of the decision-making funnel, right at that moment where just about all aspects of the trade have been strategized and all risks have been properly calculated. This is the moment where you have already properly determined that the trade will fit the overall risk strategy. In the case of opening the trade, the direction, entry, and exit areas have been determined. In the case of trade-exit, the decision has already been pre-determined, and the only thing left to do is execute.
While these strategies don't particularly apply to traders (or perhaps I should say investors) of larger time frames, as execution becomes more of a trivial matter, it's a whole different ballgame for short-term traders, where the combined efficiency of execution (or lack thereof) adds-up to values we cannot ignore in one year of active trading. The execution strategies we are discussing today is addressed to traders who carry a high rate of frequency: that's for intraday-traders and very short-term swing-traders that are exposed for only a few days at a time.
There was a brief time in the stock market, somewhere in the late 90's and towards the early 2000's that the routing strategy in execution played a very critical role. Direct-access was so new that there were many "markets within markets" to route our orders to. There was SOES, SelectNET, SuperDOT and a multitude of ECN markets. This was crucial particularly because spreads were displayed at a minimum teenie, or 1/16th sizes – that's over 6 cents in today's view, which may not sound like much, but compounded over hundreds of round-trips really added up to something. Well, the market has since evolved greatly and very fast. The many "markets within markets" have merged, and perhaps the greatest effect was the switch to decimalization. Veteran traders will tell you that decimalization and the merging of markets which has resulted in narrower spreads have altered the landscape of execution strategy to a much more simplified, streamlined and efficient method that is beneficial to us all.
Now the landscape may have changed, and spreads may have narrowed down to pennies, but some execution strategies have remained, as we find that these come into play in the compounding effect of dozens of trades (or even hundreds, and to a rarer extent, thousands). Sitting right at the heart of these execution strategies is liquidity and the recognition of momentum.
First things First: Don't Penny-Pinch. Before we get into momentum, we must first acknowledge two things:
1. Execution is at the BOTTOM of the decision-making funnel. On a per-trade basis, determining direction and entry/exit area carry far higher importance than efficiency of execution – this is only an "added bonus" of good trading.
2. The markets have evolved to a point that the narrow spreads today are a common condition.
Occasionally, the execution of a trade (either entry or exit) calls for a high degree of urgency. In those cases, if you absolutely must execute, don't worry about efficiency. Penny-pinching is common to rookie traders who are still in the mode of learning many things all at once. If you absolutely MUST get in or out, the last of your worries should be whether you got hit on the BID or OFFER side with a Limit-Order. Being a miser for pennies has cost traders more dimes, quarters and even dollars than a thousand slot machines in Vegas. When you have made the decision to execute an urgent trade, load the Market Order and FIRE! After all, if you are trading for more than dimes in a liquid market you can rest assured that spreads are narrower today than they ever have been in history. Send the Market Order and be done with it – this gives your mind the room to focus on the larger trends at play, which you should be doing.
Execute at Maximum Momentum. At the heart of efficient order execution is momentum and the recognition of momentum. Many traders get way too caught up in the perpetual brawling that occurs at the inside market on the Level 2 screen, that they fail to recognize the valuable opportunities that accompany momentum and velocity. Remember that momentum and velocity are only temporary conditions, as the market constantly alternates between waves of buying and selling. You want to execute at maximum momentum. Sell when the momentum is up, and BUY when the momentum is down. Rather than being one to chase the market all the time, let the market come to you, both IN and OUT at every opportunity. What you are doing is bucking the maximum momentum of a smaller trend in favor of a larger trend later.
Recognizing Momentum. Many traders have trouble recognizing the momentum off the Level 2 screen. In that case use the one-minute charts which is the best view of minutia momentum. If you are Long when the market is rising, don't use a Market Order to Sell, but instead let the market come to you and chase up to your Limit Order. After all, they want what you are holding. You will find that for scalp trades in particular, the best time to execute is when the 1 minute charts are hitting maximum, parabolic momentum. For regular Day (non-scalp) traders, the 3 and 5-minute charts will be more adequate, and for swing traders up to 5 trading days duration, the 5 and 15-minute charts are an appropriate measure of momentum and this would include the "invisible" bars we commonly refer to as gaps! (To a swing trader, executing out of a trade right into a gap is critical and strategy. After all, a gap is a form of maximum momentum).
Playing the Spread? Some traders like to play the spreads on larger-priced stocks which tend to have larger distance within the Inside market. Some might even make the critical mistake of wanting to play a spread in a stock that is illiquid, and thus possessing the symptom of wider spreads. Well, this is a tricky game, but once again momentum lies right at the heart of it.
There is a reason why you get hit "at the Bid" or hit "at the Ask." When the momentum is down, you get hit at the Bid, and vice versa with upside momentum – you get hit at the Ask. You will find that in rising stocks, it is much easier to get hit at the Ask (selling) than it is to get hit at the Bid (buying). When I am day-trading on the Long-side, I will often send "probe" orders at the Ask (to Sell) just to see how "hungry" the market is for the stock at any one particular time. I will take some of my shares and sacrifice it to measure how quickly the market will take it at the moment. If it gets taken very quickly, the market is hungry for it, and I have a good chance to sell the remaining shares at a few levels higher. If it takes too long, I am ready to send the Market Order to dump all my shares. If you are thinking about playing the spreads, remember that there is a reason why you are getting hit at the Bid or the Ask – and that it is when the momentum is in the opposite direction of your order… something to think about when playing the spread game.
Confirmation Costs Money. Perhaps the most important discussion in execution strategy is the battle between seeking "confirmation" and actually executing. Confirmation costs money. I am sure that all of you who have actively traded have experienced the euphoria of being in a good trade that is moving very nicely in your favor. You are enjoying the moment, everything that you have worked for is now paying off. You are Long, and you are watching the market rise to the stratosphere. (Or perhaps you are Short and you are watching this market crumble to the core of the earth as your account balance is the one rising to the stratosphere). And then slowly the market loses some of its steam. This might not affect you since you are deeply in the money, you are on board the few seats in the First Class cabin and everything will be fine. The price pauses. The pause continues. And continues. And then slowly the market begins to creep in the opposite direction. You remind yourself this is normal, and continue to sip on the special Tea that they serve only for the First Class passengers. The pressure picks up steam and the market is now violently going in the opposite direction… and suddenly it is only NOW that you realize that it's time to exit the Space Shuttle. You desperately send the order to get out of your position, and realize that in the course of enjoying and maximizing your greatest moment, you lost half your profits. Confirmation costs money. Dump your trade and take your profits at maximum momentum. You will find that when you execute at maximum momentum, in most cases you will not regret your decision. After you have executed, then and only then is the time to sip on the First Class Tea. As the rest of your opponents scramble to get out seeking "confirmation" you are well on your way to strategizing your way aboard the next blast off on the Space Shuttle … only in First Class, of course.
Until next time, happy trading!
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Fernando now enters his 10th year
as an active trader, technical analyst and content contributor to the Active Trading
community and a long list of popular financial media. In 1999 he authored the
best-selling book