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Trading
Components |
The
Components Of A Good Trade - Defining
Strategies For Success
This
section will describe the necessary components
of a good trade. A “good trade” is one
where the trader understands the potential
and the RISK involved with the action
he/she takes. A good trade should include
the following components.
1.
Review
the chart (both Daily and Weekly)
for support and resistance levels, price
gaps, trend channels, the locations of
Dojis and Hammers and the reactions of
the technical indicators. First, review
the Weekly chart for overall market trend
indications. Then, review the Daily chart
for shorter-term trend.
This
is a critical process to become aware
of the past actions of the chart and to
begin to identify IF this chart is one
that we should consider trading. We should
be looking for …
What To Do... |
A.
Consistent Price Swings
- price action that moves
up and down in a consistent
manner making defined tops
and bottoms. We should also
be cautious of extended congestion
areas within the chart – these
will likely result in draw
downs and losses.
B.
Past Support and Resistance
Levels
- these are previous tops
and bottoms that have occurred
in the chart. We use these
to gauge the potential of
the market’s price swings
and to formulate the “potential”
of this chart in terms of
“dollars vs. Risk”.
C.
Price Gaps
- These are critical because
they represent extreme market
price action and often are
“tell-tale” signs of support
or resistance.
D.
Trend Channels
- We should attempt to determine
is the chart shows any defined
trend channels to become better
aware of the current conditions
of the market. Trend channels
are essentially “sloping”
support and resistance levels.
E.
Dojis and Hammers
- These candlestick formations
are the “early warning” signs
of market reversals and potential
breakouts. We should look
through the chart to find
out if these candlestick types
have formed “regularly” near
key reversal points. We should
also look for them as signs
of additional (hard to find)
support and resistance levels.
The BODY’s of Dojis and Hammers
are often support and resistance
that carries into the future
of the chart.
F.
The Reactions of the Technical
Indicators
- we are really just looking
for the technical indicator
to react “properly” with every
trend reversal. This means
swings from upper to lower
extremes through the price
trends. If we see good reactions
– it is more of a positive
sign this chart exhibits good
price trend and technical
indicator actions.
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2.
Identify
The Potential (What is likely to come?).
Use the information you have attained
from the chart to try to identify what
is likely to happen in the future. Remember
to consider the particular chart you are
looking at in comparison to its Sector
and the general market conditions. Some
stocks will move “counter to” the current
general market conditions, while others
will tend to follow the general market
conditions.
This
is another critical process to try to
identify the best potential solutions
to trade. This is where you try to identify
the likely outcome of the future price
moves. Things to look for are …
What To Do... |
A.
Are We Near A New High Or
Low?
- If the current price is
near a recent top or bottom,
then try to identify the support
or resistance levels that
exist on the chart and look
for trend channels and indicator
channels.
B.
If We Are Not Near A New High
Or Low?
- This would indicate that
there is, potentially, further
trend action yet to occur
before this chart reverses.
This would mean that one could
attempt to trade with the
current trend after establishing
a potential profit target.
C.
Are there any Chart Patterns
(candlestick or other) or
Indicator Patterns
- Look for candlestick patterns
on the Daily and Weekly charts
as well as other types of
price patterns. Also, look
for indicator patterns such
as divergence, convergence,
flags or other types of technical
indicator patterns to help
confirm your analysis.
D.
Try To Identify the most logical
potential future for the chart
- After reviewing the chart,
try to identify the potential
short-term future of the chart.
This means that you should
try to identify the next 5~10
days or weeks activity of
the chart. Based on what you
know, what do you expect the
market to do?
E.
Try To Identify the opposite
of what you expect the as
the “most logical potential
future for the chart”
- This is where we identify
“What if I’m Wrong”. This
is probably one of the most
critical components in decision
to trade process. We all can
try to WISH a stock price
higher, but we all know it
won’t help. We need to plan
a strategy that we can use
in the event the trade moves
against us.
F.
Calculate The “Reward To Risk
Ratio”
- use this formula to calculate
the “Reward To Risk Ratio”.
This is a simple means of
determining if the proposed
trade is worth your time or
not. It simply puts your potential
risk and potential gains in
perspective.
For Long Trades:
(Proposed Profit Target –
Current Price) / (Current
Price – Stop Loss Level)
Example: Current Price: $12.25
Profit Target : $13.50
Stop Loss Level : $12.00
($13.50 - $12.25) / ($12.25
- $12.00) = 5.00 or a 5:1
Risk/Reward Ratio.
For
Short Trades:
(Current Price - Proposed
Profit Target) / (Stop Loss
Level - Current Price)
Ideally,
you want to keep your trades
above a 3:1 risk reward ratio.
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3.
Review
Other Potential Candidates Within The
Same Sector. Once we have
reviewed the Daily and Weekly chart and
have determined a potential outcome as
well as a potential “what if I’m wrong”
scenario, then we should review other
charts in the same or similar sector for
confirmation of your analysis as well
as to see if the other charts present
any better potential outcomes. Most investors
know that market sectors move in similar
fashions, but not always the same. If
you identify a BUY signal in one stock.
This
process is important because this process
allows us to review our analysis against
other similar market segments and charts.
Often, more than one symbol in a market
segment will be reacting similarly – presenting
multiple opportunities. It is our job
to find the best opportunity.
What To Do... |
A.
Look For Similar Shapes in
multiple charts
- If the current price is
near a recent top or bottom,
then try to identify the support
or resistance levels that
exist on the chart and look
for trend channels and indicator
channels.
B.
Look For Similar Types Of
Signals (Candlestick or otherwise)
- If there are similar types
of candlestick patterns or
other price patterns on multiple
charts within the same market
sector, then there is a possibility
that the entire sector (or
a portion of it) are getting
ready to make a move. This
presents an opportunity for
“diversification” and for
us to expand your trading
opportunities.
If,
on the other hand, we find
the other charts do not confirm
our initial analysis, then
we might want to spend a little
more time waiting for the
right conditions before entering
a trade. Sometimes, the market
may look like it is going
to bottom or top, but doesn’t.
The best advice I can give
is that it is better to execute
your trade AFTER WE HAVE FOUND
A CONFIRMED BOTTOM OR TOP
rather than many weeks before
with the assumption of a bottom
or top.
C.
Look For Similar Technical
Indicator Formations
- This is just like looking
for similar price action,
but instead, we concentrate
our analysis at the technical
indicators. The reason for
this is that the technical
indicators are designed to
help us understand the conditions
within the marketplace at
the time we are investigating.
If the technical indicators
are ripe (and we’ll discuss
in future sections of this
book what makes them ripe)
and the price action is promoting
a potential reversal, then
we have a stronger chance
of a profitable trade.
D.
Use the Risk/Reward Ratio
to better determine our options
and to determine your exposure
to the trades
- If the Risk/Reward ratio
is greater than 3:1, then
we have a decent opportunity
with this trade. Be aware
that if the “profit target”
portion of the risk/reward
ratio reflects a price that
has not been reached in recent
trading, then we should revise
our profit target to within
recent price action. In other
words, don’t buy a $3 stock
and expect it to move to $30
(a four year high). Use the
recent highs of the past few
months.
E.
Try To Use This Information
To Confirm or Deny Your Analysis
- Try to use the information
you have gained from these
steps to determine the proper
action one should consider
taking to trade. Also, if
this process does not confirm
that we should take a chance
and trade this chart, then
it is probably better to wait
and look for other opportunities.
I can’t tell you how many
times I have wanted to trade
some stock, then found a better
opportunity by simply waiting
another few weeks.
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4.
Decide
If Now Is The Time To Trade Or Should
You Wait? Once we have
completed steps 1 through 3, it is time
to decide if NOW is the time to execute
our trade or would we be better off waiting
to execute our trade. We can argue both
sides of this question. The answer is
“sometimes it is better to execute now,
other times it is better to wait”.
This
process is important as it reflects our
“timing” the trade. As we’ll see in future
examples that the outcomes of both have
strengths and weakness’, and we’ll see
how each side of this “timing” issue plays
out. The bottom line is that sometimes
it pays off to wait to enter a trade and
other times it does not. Here is what
to consider when trying to “time” our
entry.
What To Do... |
A.
Do you believe the market
will pull-back or retrace
from the current levels?
- If our analysis shows a
potential for a market pull-back
or retracement from current
levels, then the best solution
is to use Fibonacci levels
of the most recent short term
price action as a guide for
the future retracement. Normally,
a 38%, 50% or 62% retracement
will be our ideal entry price
levels. Also, if we believe
the market will pull-back
but it does not, it is often
wise to use a limit order
to enter our trade on a breakout.
In this event, we will use
the limit order as an option
if the pull-back trade is
not executed.
B.
Do you believe the market
is accelerating in its current
trend?
- If the market does not appear
to be pulling-back or retracing,
then often is it wise to enter
the market with a “Market
Order” or use a “Limit Order”
with a price just above current
resistance. With the limit
order, we are essentially
attempting to enter the market
as it begins to accelerate
in the predicted direction.
With the market order, we
are simply saying “get me
in at the current market price”
(or close to it).
C.
Is there a defined support
or resistance level nearby?
- If there is a defined support
or resistance level near the
current market price? If so,
what did the market do in
the past when it reached this
support or resistance level?
If the market price bounced
off of this level in the past,
then we should expect it to
bounce now. Remember, support
and resistance is not like
concrete. It is like a rubber
floor – the market can move
below support or above resistance,
then bounce back. The basis
here is that past support
and resistance play very important
roles in future price moves
– use them as guides to the
potential future move.
D.
Are there any trend channels
in play currently?
- Trend channels are sloping
support resistance levels
that the market price moves
between. Most of the time
we can look for significant
highs or significant lows
and simply draw lines across
the highs or across the lows
to find these channels. There
are also multiple trend channels
on a single chart with a single
trend. The best way to use
these channels is to identify
the primary channel first,
then identify sub-channels.
The primary channel is the
one that is closest to the
current market price.
If
the current market price is
within the trend channel,
then we might choose to wait
until a confirmed breach of
the channel is formed. Until
the channel is breached, we
should expect the market price
to continue to move within
the channel levels. If we
choose to trade counter to
the trend channel direction,
then we should only attempt
short term/aggressive trades.
E.
What is the current general
market condition (and how
does it relate to this chart)?
- What is the current “general
market” condition? If the
general market condition is
good and the other charts
in the same sector as the
one we are considering to
trade look strong, then we
have greater confirmation
of the potential future of
our trade. If the general
market conditions are poor
(or very poor), no matter
how much we want your trade
to work out, the conditions
might deteriorate and cause
a loss. This is when we might
decide to wait and use the
“limit order” option to try
to execute a trade when the
market accelerates.
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5.
Execute
Your Trade? After resolving
our decision in step #4, the next step
is to execute our trade (if the timing
is right), or not (skip to step #6 or
#1). Executing our trade means choosing
a type of trade (at the market or limit)
and establishing and placing our stop-loss
trade.
This
process is actually rather simple. It
requires two steps, executing the trade
and executing the stop-loss order. Deciding
our stop level is discussed in “Choosing
Stop Level Strategies”.
What To Do... |
A.
Do we Execute a “Market Order”
or do we execute a “Limit
Order”? -
This is probably the toughest
decision we’ll make. The issue
here is do we simply enter
a trade (a market order) or
try our best to time the trade
and the entry price (with
a limit order). Generally,
market orders provide a faster
way to get into a trade, but
include potentially greater
risk because of the lack of
timing/pricing it provides
– we get in when we execute
the order at (or near) the
current market price. The
limit order allows us to specify
an ENTRY PRICE that we “would
like” to execute our trade
at. If the market reaches
(or breaches) this price level,
our order gets executed. If
not, our trade is NOT EXECUTED.
The
Market Order is executed almost
as soon as we place it. The
Limit Order can be issued
as a “Day Order” (only good
for one trading session) or
a “Good Till Cancelled (GTC)”
order where it will stay active
in the markets until WE CANCELL
IT. Be cautious with GOOD
TILL CANCELLED orders as I
have heard stories of people
leaving GTC order on for months,
then getting filled when they
didn’t want to.
B.
Placing a “Good Till Cancelled
Stop Order”.
- After we decide and place
our Entry Order, we almost
always want to place a Stop
Order. The Stop Order protects
us if the market moves against
our open trade. In most cases,
it is critical that a stop
order is generated with all
entry orders. Some traders
may choose to take additional
risk and enter a trade without
a stop order, then place one
later. Generally, if we can
identify “how much we are
willing to risk on a trade”,
then we should place our stop
order with every entry order.
Entering a trade without a
stop order increases our risk
tremendously.
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6.
Tracking
Your Open Trades.
After executing our trade, it is critical
that we track the open trades (especially
if we place a trade WITHOUT A STOP). Market
conditions change all the time. As professional
traders, we MUST review our analysis and
review our exposure to the market at all
times. The other most important factor
is to NEVER LOOSE SIGHT OF THE GENERAL
MARKET CONDITIONS. Even though we may
have followed this guide perfectly and
executed the perfect trade, if the general
market turns against us (for whatever
reason), we need to move into “recovery
mode”.
This
process requires us to diligently watch
our open positions and the conditions
of the market in general. The reason for
this is that the stock market consists
of many broad factors – any of which could
move against us at any time.
What To Do... |
A.
Are the market conditions
still prime for your trade?
– If, after we execute our
trade and the market has not
moved as we expected, but
it has also not reached our
stop price level, then we
should reevaluate our trade
and the conditions currently
within the market/chart. If
the conditions are still as
we found when we executed
our trade, then we might consider
reevaluating our stop level
(or not) and continue to let
our trade play out. If the
market conditions have changed
(for better or for worse),
we should start this entire
process all over again and
decide if we want to continue
with this trade. If not, get
out and wait for a better
opportunity.
B.
Do we need to adjust our stop
level?
- In most cases, if the market
HAS moved in the predicted
direction and our trade has
some profit, we should consider
adjusting our stop to reflect
the current market conditions.
We discuss this in much greater
detail in the “Choosing Stop
Level Strategies” section.
C.
Has our trade moved in the
predicted direction?
- If this is the case, don’t
go crazy and buy a new Porsche.
Now is the time to continue
evaluating our trade and consider
revising your stop level.
D.
Is it time to pull profits
and what strategies should
we use?
- This question is very difficult
to answer because every trade
presents a unique situation.
The basis for any decision
to pull profits should be
because of the following reasons…
a. We are concerned
that the market may move against
us and we don’t want to leave
the current profits open to
potential loss.
b.
Our trade is moving well in
the predicted direction and
we want to cover the initial
capital (or a portion thereof),
then we should sell a portion
of our holdings and adjust
our stop level.
c.
The market price has reached
our initial profit target
but could go higher, then
sell a portion of our holdings
and adjust our stop level.
d.
We’re satisfied with the trade
and the profits. Exit our
trade and cancel our stop
order.
E.
Did the trade move against
us and get stopped out with
a loss?
- If this is the case, then
WELCOME TO TRADING. We are
experiencing what all of us
experience at some time or
another. This business is
just like any other business,
we take risks and execute
our trades based on our best
abilities. In doing so, some
of our trades will be winners,
others losers. The end result
should be that over time,
our gains are greater than
our losses.
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At
this point in time, we should review the
conditions and mental decision we made
when we executed this trade. We MUST learn
from our mistakes. Spend some time going
back over the trade and decide if we executed
it in the best possible manner. Many times,
traders execute the trade perfectly, but
the stop loss level was simply too tight.
This is the most common reason why traders
get stopped out of a trade. Read more
in the “Choosing Stop Level Strategies”
to identify other potential solutions
for stop placement levels.
7.
Evaluating our past trades to gain experience
from. It does not matter
is your past trade was a winner or a loser,
we still need to go back through it and
review our actions and the market actions.
The purpose of this is to gain greater
insight as to the potential changes in
our trading strategy that we could have
used to increase our overall returns.
Could we have done anything differently
that would have helped or hurt our trade?
This
is the learning process that many traders
fail to accomplish. Sometimes, we just
get lucky and other times it is skill.
Ideally, we want to rely more on skill
and less on simple luck. Without the ability
to review past trades and learn from them,
our skill level advances very slowly.
What To Do... |
A.
Review the conditions that
caused us to execute the trade
– Review everything that caused
us to execute this trade and
every action we made while
the trade was open. Try to
identify where we can improve
your strategy.
B.
Review the conditions that
we placed when we executed
the trade
– Review the ENTRY order and
STOP order that we placed
for other potential strategies
that may have performed better.
Use the Daily chart to identify
if the Fibonacci levels could
have been used for entry timing.
C.
Review the conditions and
market price action that followed
our trade execution
– Review the conditions of
the market after our trade
was executed. What were our
decisions and what market
conditions effected our decisions?
Could we have done anything
differently or did we miss
something that could improve
our results.
D.
Review our actions throughout
the trade
– Did we become emotional?
Did we do anything to potentially
reduce our effectiveness as
a trader?
E.
Decide if we believe we acted
properly or not
- What did we do well and
what could we have improved
on? – After reviewing everything,
take the time to praise our
self for the actions we preformed
well and learn from the actions
we preformed poorly.
F.
Take this information to our
next trade and USE IT
– Use all of this information
on our next trade. Try to
improve on our strategy and
try to learn from our past
mistakes. |
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