Seven Steps To A Good Trade

1. Have a trading plan. This is the beginning and the end to all good trades. Traders agree it is a good idea, but when you inquire further, you will find that few actually have a detailed, written trading plan. Beyond that, you will find that many of those who do have trading plans do not consistently use or follow up on them.

   Since you are in the business of trading, your trading plan is also your business plan. Thus, it must be written out and contain detailed information. It should lay out your goals, both esoteric and monetary. It should have proper money management rules to handle both trades that are attaining your goals and trades that are not. It should set out how to handle winning trades, and have rules for when and how to quit when losing. It should have detailed strategies that include requirements and times when you may trade, such as the market conditions for entries. It should also identify times when it is best for you not to trade.

2. Search for the best trades with a mental picture of your setup. Whatever strategy you are using to find trades, you need to reduce your requirements to a mental image of the chart you want to see. This will allow you to look at many charts and focus only on the ones that are consistent with your strategy. Many traders feel the need to look at a given chart and study it until they find a possible play. But in fact, few charts will lend themselves to a good, quality trade. Do not try to make something out of nothing. Look for good setups that meet your criteria (and don't change your criteria to meet what you see!). Those criteria should form a picture or pictures in chart form. Set aside those charts that form the picture and evaluate them more thoroughly. Upon later review, use a point system to rank your picks based on your key setup criteria. This will help you maintain your objectivity.

   Do not look at names of the stocks when you are scanning; just looks at the charts themselves. The names can take away your objectivity. In addition, do not impose your view of where the overall market is headed on your perspective of the charts you are examining, which can cause you to ignore potentially profitable charts that are pointing the other way. No one can predict the market; it is best to be prepared to go either way.

3. Compare the potential reward to the potential risk. Your strategy should clearly define a target area and stop-loss criteria. If the target or stop is going to be achieved in multiple parts, take an average of the projected stops or targets. Come up with a reward-to-risk ratio that you can live with and compare it to your trading plan. Different trading styles and time frames will allow for different reward-to-risk ratios. This ratio may vary from just over 1.0 to 10 or higher, depending on your percentage of successful trades and the type of trades that you do. The shorter-term your trades are, the more likely you will have a higher percentage of successful trades, with a lower reward-to-risk ratio. Note that at this point, you are objectively deciding whether the trade is acceptable. The numbers are derived from the chart and cannot be changed. If the ratio is not acceptable according to your trading plan, discard the trade and keep looking. If it is acceptable, move on to the next step (see Figure 1).

   

   Figure 1: Analyzing risk to reward. Here is an example of a long play on the QQQ on August 8, 2002. As the morning pullback rallies and begins to challenge the day's high, a base forms on the 15-minute chart. Suppose you buy above 22.90, just over the top of the three-bar base, at point A. Your stop is going to be under 22.64, at point B. Your target will be to sell at yesterday's high, 23.40 or point C. Your potential reward is 4.50 (23.50 ­ 22.90), and your potential risk is $0.26 (22.90 ­ 22.64). This gives a reward/risk ratio of almost 2:1, excluding slippage and commissions. If this ratio is acceptable based on your trading plan, proceed with the analysis. Otherwise, pass the trade and move on.

4. Consider the relative strength or weakness of the stock to the market and sector; consider the timing of the trade. If everything about your trade is a "go" up to this point, you now want to get the odds in your favor as much as possible. Depending on your time frame and trading style, this step may be critical — or it could be one of lesser consideration. If your strategy has an entry point on a certain time frame, you may want to pass on the trade if the stock ran a good deal to get to that point.

   For example, let's say your stock has set up a midday base, and you intend to make a daytrade when it trades over that base. You envision a nice breakout from the top of the base after lunch and intend to hold the stock until near closing time. Would it affect your decision if the stock dipped down to the low of the base and made a very hard run to your entry point? Would it affect your decision if this happened during lunch, when you know this type of trade has a high failure rate? In this case, the timing of the trade may be bad. The trade may still work under the strategy and the entry point you chose. However, the odds may be reduced, or a better entry may be available.

   Suppose the stock you are following is a key Nasdaq stock. What if the Nasdaq futures put on an impressive rally from 2:00 until 3:00 pm ET? During this time, your stock could not trade above the base. Then at the very end of the rally, as the Nasdaq futures run for an hour right into yesterday's high, your stock triggers above the base. Do you take the trade? Or has it shown such poor relative strength that you would feel the odds have changed and it is better for you to pass?

5. Calculate the proper share size requirements for the trade. Even when everything is going well, and your trading plan is hitting the numbers you want to see, you may still get occasional bad trading results. If you take too large a risk on too few trades, your plan may not have the ability to endure. Knowing how to play the proper share size is key to managing risk and maximizing results. You may wish to consider equalizing the risk on all trades you take by standardizing the dollar amount that you would lose if your stop hits.

   Every trader must spell out in their master trading plan (see step 1) the maximum amount of money they are willing to lose on a bad day before shutting down. They must also fix the maximum they are willing to risk on any one trade. Most use a percentage of their account to determine this number. This is a personal choice you should consider carefully. It will vary with the time frames you select to trade. For example, many day-only traders will not risk more than 0.5% of their account on any trade: half of 1% of the value of their account. For swing or core trading, some people will go to two to five times that amount, as the trades are less frequent. By equalizing risk, you are eliminating the desire to "go big" based on your gut instinct. Your share size increases when the stop justifies the size.

   While varying the risk from play to play is not acceptable, you may decide that at certain market times the odds may be lower. If you are still going to trade, you may consider reducing the amount of capital you are going to risk on any trade.

6. Manage the trade. Often, this means to do nothing. Most traders, especially new ones, overmanage trades. They exit trades before they develop, without proper reason. If you have followed your trading plan and have a valid trade in play, letting it hit your chosen target or stop is usually the best course of action. On occasion, there may be cause to exit a trade early. You should have disciplined rules set up that will allow you to exit early. If one of these three conditions happens, you should:

   First, consider exiting early if a news event with serious ramification hits. Depending on your time frame and the severity of the news, this may apply more or less to your situation. If Federal Reserve chairman Alan Greenspan makes a surprise interest rate adjustment, or if terrorists strike, you may want to exit and let the dust settle. This is prudent.

   Second, consider exiting early if your trade was based on the assumption that the market would maintain a certain direction, and that direction changes based on objective criteria. Suppose you entered a long daytrade based on the market trending up over the last two days, and you use a 60-minute chart as your guide for market direction on intraday trades. The 60-minute chart puts in a lower low and lower high. If these are your criteria to play the short side of the market, you may choose to exit the trade, even though your stop has not hit yet.

   Third, consider exiting early based on a time stop. This means a certain period of time elapses, usually defined as a certain number of bars on the chart of the time frame you are trading in, where you have not reached a target or stop. Many traders will consider that if their trade was a good one, it should have reached its target or close to it after a reasonable period. Included in this category would be traders who manage their trades on a bar-by-bar basis, evaluating their options as time passes and their goal is not yet met. Naturally, whether or not you apply any of these exceptions, the worst-case scenario is that your stop hits. Never violate your stop.

7. Follow up on your trades. Analyze all trades. Print charts and review your trades. Did you apply the last six steps correctly for each trade? Use this information to eliminate mistakes and problem areas, and to review and evaluate your trading plan. Unfortunately, many traders do not even consider this step. If fact, a good deal of a trader's time should be spent doing follow-up evaluations on trades — perhaps even more than is actually spent trading. Too many traders lose the valuable lessons contained in losing trades. Most choose to ignore bad trades, or try to forget them. Good traders analyze their losers, and try to learn the lessons that every bad trade can teach. Maintain a consistent plan for recordkeeping, trade analysis, and eliminating mistakes. Maintain a schedule that includes time for ongoing education and some time off every week.

A list like this one should help you improve your trading. However, it will do little good if it is not used and enforced on a daily basis. Most traders have the necessary tools available to them, but many lack the discipline to put those tools to use.

Paul Lange is the head moderator of the Pristine Method Trading Room and does private mentorships for Pristine.com. He can be reached at plange@pristine.com.

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