Sunday, June 3, 2012

Three Steps To A Trade

In order to survive in trading, one must have a systematic approach for putting on a trade. For me, I use a three steps approach. The three steps are: 1) the setup, 2) the trigger, 3) the exit.

The first step is to identify a setup. The setup can be anything that you find to give you an edge in the long term. The edge does not have to have a high win/loss percentage. It can be an edge based on high average winnings/average losses ratio. There are successful traders that use setups having win/loss percentage in the 30% range, but with very high average winnings/average losses ratio. Essentially, these setups experience many small losses with few big winnings. And the winnings are much more than offset the losses.

Setups can be based on a particular price action, a corporate event, seasonality factors, etc. The setups I use are based on price actions. Some of the setups I use are: formation of a price pattern, a breakout of a trend line, a bounce off a support. Here is an example of a price pattern setup I recently used for a swing long trade on AAPL. This is a triangle price pattern with two successful bounce off the 200 SMA.



After a setup has been identified, the next step is to determine a trigger level. In this example, the trigger level is the breakout of the last price point that backed off from the upper descending trend line of the triangle. Notice the multiple test of the trigger level prior to the last pullback.



Once the trigger has been established, the final step is to identify the exits. I consider this to be the most important step of a trade. The first and foremost exit is the stop loss. This stop loss level and the trigger level will definite the risk and help determine the position size for the trade. This is like an analogy to a game of blackjack. You determine how much you want to wager for a hand of blackjack, and the amount you have wagered is the amount at risk (provided you don't take those sucker bets such as insurance on a dealer's Ace face card or split & double down.) Without having determined the risk to place on a trade is like playing a hand of poker betting all-in without looking at your cards. This type of poker strategy can mean game over for you on a single hand, and without establishing the risk for the trade can blow up your trading account on a single trade.

In addition to the stop loss exit level, potential profit exit levels are also identified. These exits levels will determine if the trade is worth the risk. In my trading plan, each trade must have the potential to return multiple times of the risk taken. If the profit exit levels show the trade have the possibility of returning at least two times the risk, then the trade will be taken when it trigger.




I believe using these three steps to put on a trade have helped me on reducing impulse trading and reduce the emotional roller coaster after the trade is put on. It defines the risk and establishes a plan on managing the trade...before putting on the trade.

Here is what happened to the trade.




I can assure you, most of my trades do not work out so perfectly as this AAPL trade. I hope this three steps approach to a trade will help provoke some thoughts to some of you on how to improve your trading strategy.


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