Ask yourself why do you want to trade?
Many people would say that’s obvious – I want to make extra money, or I want to work for myself. If that is the case for you, it would follow that to make money you need to have a businesslike approach to your trading. Making money from trading is not difficult, but it is also not automatic. It is like any other career path. You must put in the time and energy to learn your profession, like you would with any other business or career.
If your trading is just a hobby, or you just like to have a bet on the markets like you would on a sports game, then that’s OK too.
But beware! If you start out thinking that I am happy to risk $1000 to try trading, then that is most likely exactly what’s going to happen. You will lose your $1000!
Trading with an arbitrary and unsystematic approach that is more to do with luck than good judgement is little more than gambling. So many times we have seen traders who start out with some (often big!) wins, and then lose it all. Without applying a systematic and disciplined approach to your trading, utilising proven trading strategies, your chances of success are very small.
The outcome in your business of trading does not rely on luck. It is the result of your hard work; the result of setting goals, creating a plan and implementing that plan.
Your trading plan should cover these three critical steps:
1. Market Analysis
2. Defining your Trading Strategy
3. Your Trade Management Plan
Define what you will trade and when, do you homework to find those opportunities and then manage your trade. Simple!
Step 1: Techniques for market analysis
Market Prep is an essential process you need to undertake before beginning any trading activity. You are trading blind if you start entering trades without having completed your Market Prep.
Your Market Prep should include an analysis of the market to date. This analysis may be on a number of different timeframes depending upon your style of trading. The analysis will include different steps depending upon what instruments you are trading.
For example, if you are an intra-day futures trader, your analysis will focus on the specific futures market or markets that you trade. On the other hand, if you invest in stocks end-of day as a position or swing trader, your Market Prep will include a scan for stocks that meet your entry criteria.
For a stock market investor , your market prep should include :
1. A review of general market conditions. You should consider if there are any major news stories or events that may impact the market. In particular you should determine if there are any key economic data or reports due, and any key trading dates such as options expiry. Then look for any company reporting dates of either positions you hold, plan to invest in, or for large companies that are likely to impact the sector you are investing in.
2. An analysis of the daily chart of the overall market to date to identify key trading zones including major and minor support and resistance areas, the current state of the market (ie trend or consolidation) and an assessment of the next likely direction for price movement. Include in your analysis key price zones in which you expect to see trading activity based on your analysis.
3. A scan of stocks to identify potential investment opportunities based upon your investment strategy or strategies.
The next step in your Market Prep is to consider any open positions you are holding. Review the initial investment strategy and determine if the original premise for holding these positions is still valid. Determine your trading strategy for these positions, in particular your exit strategy, profit target and stop loss strategy.
Consider keeping a trading journal. Determine your plan for recording and reviewing trades for each trading session. Also determine your plan for your longer-term review of your trading, including review of weekly (or monthly) goals and setting of new goals.
Determining Market Structure
The market moves between four basic structures:
➢ An uptrend where the price is generally increasing over a longer-term period
➢ The uptrend is followed by a consolidation where price moves sideways, oscillating between two price points.
➢ A downtrend where the price is generally decreasing over a longer-term period
➢ A downtrend is followed by a basing period where price moves sideways, oscillating between two price points.
The diagram above shows different market cycles when an uptrend is followed by the market topping, a short consolidation and a new down trend develops. As a trend becomes exhausted a basing period takes place in preparation for a new trend to develop with the process repeating.
Notice that the retracements within the trend are marked with red and green boxes. These boxes define the premium areas where we look to trade the markets.
Understanding market structure is a key to developing timing techniques. Price action moves in different cycles from expansion in price levels (trends) to a contraction in price levels (consolidation or base periods).
Price expansion occurs as market participants move in from the sidelines bidding higher prices or accepting lower prices. This forces traders already involved to accept losses or take profits to close their open positions.
In up trends and down trends, countertrend moves (retracements) will flush out market participants as traders exit out of fear of losses or decreasing profits. Once the majority are on the sidelines the financial instrument can attract new buying/selling demand which pushes prices to new highs or lows.
Step 2: Defining your Trading Strategy
Your trading strategy is determining the premium retracement zones in a trend that meet your defined criteria. Your trade entry is the point where you move from analysis to trade management. This is when you take on the emotional and psychological aspects of trading.
All your fears and hopes come into play when you have your money out in the market!
Fine-tuning your entry skills will not only help increase your profits, but also help you build your confidence. Feeling confident that you have selected a great entry will create a positive mind-set for the remainder of your trade. Feeling unsure about your entry is not conducive to a successful trading outcome.
We will consider a number of factors that increase the probability for a successful trade, however we will not be providing a prescriptive list of criteria. The market is a mass of individuals all making independent decisions based on their own situations and perceptions. As a result, the market does not always fit into nice neat patterns and rules.
The key is for you to learn how to read the market, understand the current market environment, assess your risk-reward ratio, and use these factors as the basis for your decision.
Keep in mind that to build the skills for executing effective entries over time comes through practise and experience. You will also find that you might utilise a combination of techniques depending upon the situation.
Guideline for structural trade setups with trend
The context of the market is key.
➢ Wait until the transitional or basing stage plays out.
➢ Look for price to break the range.
➢ For “long trade setups”(upside movement) most price bars must be above the Moving Average
➢ Look for price to retrace the breakout leg.
➢ Anticipate that the low of the retracement will be tested at least once before the major trend resumes.
Example 1 Low and High risk areas to trade in relation to the Moving Average
This chart had a transition/base stage playing out from August 2011 to December 2013.
Price prior to this had been falling (Downtrend). We do not initiate trades in this environment as it is obviously very difficult to make money trading when the price is steadily falling with only brief upside moves.
The transition period is where price moves in a band. Not making large moves higher and also not making new low prices. As a transition stage evolves it helps us to acknowledge that selling pressure is dissipating and buyers and sellers are closer to an equilibrium.
For conditions to be favourable for a trade, we want to see signs that buyers are prepared to step up to the plate and bid higher prices than in the past. (Accumulation phase)
Once this occurs price will mostly hold above the moving average which in this example is set at 33.
We are looking for potential buy areas in low risk areas which are marked.
We look to reduce position size or avoiding buying in the high risk areas as marked which are away from the moving average line.
Think of the moving average as a rubber band. The further price moves from the moving average line the higher the risk that price will snap back to the moving average.
Many traders have heard “retracements from trends are a great way to trade”. I agree with this view. However, I also strongly believe that patience and timing is crucial to creating a significant edge as a trader.
Taking your analysis a step further, and by anticipating a second and sometimes a third probe before price holds, you can ride the predominant trend with higher success rates without being stopped out prematurely. These appear on the charts as a “W” type formation.
Our exit strategies rely on our price analysis to tell us when market sentiment is changing and there is a potential for a price reversal. An ongoing assessment of your risk reward ratio is also a key component of determining when you should be exiting or reducing your position.
The further price moves from the moving average line the higher the risk that price will snap back to the moving average.
Signs of weakness are signals that you can read in the charts that provide clues that the market is changing. All of these are based on an understanding of chart analysis and reading the actions of buyers and sellers.
Specific signals that you should look for include:
➢ Extended directional price moves away from the moving average increase the risk of a snap back to the moving average.
➢ “M” Type formations that form when holding a long position show a retest of a high that has failed to break higher.
➢ Tails and shadows. This is a powerful signal for a potential change in market sentiment. A large tail on the top of a candlestick shows that buying pressure which moved the price to its high has been overcome by sellers who have pushed the price right back down. A series of candlestick tails after a directional price move combined with an extended move from the moving average often marks a high risk area.
➢ Period Close. Pay attention to where the close of the period is. This is a strong signal for the most likely movement for the next period. Candlesticks that close on their highs or lows are particularly relevant.
➢ Reducing range is also a signal of a move running out of strength and a potential reversal.
➢ Price approaching a previous support or resistance area also provides an opportunity to see if this support or resistance will hold and whether the price will reverse after hitting this area.
If you are risk adverse and a conservative investor, you need to be careful that you do not read these signs from insignificant market moves and exit your positions too prematurely.
All trades will suffer retracements and price movements within a trend, and you need to give the stock enough ‘wiggle room’ to ride out these movements. Determining how much room to allow will be based on the natural volatility of the stock and your time frame. A longer time frame requires more flexibility.
It may be more appropriate for a longer term investor to employ a multi-tier exit strategy, where part of the position is exited on a sign of weakness, and the remainder exited at a technical stop.
Step 3: Trade management plan for trading consistency
Jumpstart Trading Plan
Your trading plan will define all your trading rules. This is where you determine which trades you will enter and how you will manage them. It should contain all the rules you need to follow for any price action that eventuates. It is the plan for the way you want to execute your trades.
Having set rules for any price action that occurs on your trade will assist you to trade with sound judgement and not with emotion.
➢ You have a rule if price goes up
➢ You have a rule if price goes down
➢ You have a rule if price goes sideways
Trading a Numbers Game
Rather than focussing on financial outcomes, we suggest you focus on improving your trading statistics. This is like analysing the profit margins in your business so you know where you need to improve.
The key statistics we look at are:
➢ Win/loss ratio
➢ Edge ratio.
Other statistics that can be useful in analysing your results include your largest loss, largest winner, and number of consecutive winning trades and number of consecutive losing trades.
Win/Loss Ratio or Hit Rate
Your Win/Loss Ratio is a measure of the number of times you have a winning trade as compared to your number of losing trades. We also call this ratio your Hit Rate. It represents the number of times you “hit” a winning trade.
To calculate your Win/Loss Ratio use the following formula:
Number of winning trades / Total number of trades x 100 = Win/Loss Ratio
The ratio is expressed as a percentage. For example, if you executed 50 trades and found that you had made a profit on 30 of them, then you win/loss ratio would be 30/50×100 = 60%. This means for every ten trades you enter using this particular trading strategy, on average six will be profitable and 4 will be losses.
Your Edge Ratio is a measure of the size of your winning trades compared to the size of your losing trades. A high Edge Ratio will indicate that you keep your losses very small and let your winners run to large profits. A low Edge Ratio will indicate that the average value of your losing trades is high when compared to the average value of your winning trades.
To calculate your Edge Ratio, use the following formula:
Total value of Losing Trades / Number of Losing Trades = Average value of Losing Trades
Total value of Winning Trades / Number of Winning Trades = Average value of Winning Trades
Average value of Winning Trades/Average value of Losing Trades = Edge Ratio
For example, assume of your 50 trades, you had 30 losing trades with a total loss of $5,000 and your 20 winning trades had a total profit of $10,000. Your average losing trade value is
$5,000/30 = $167. Your average winning trade value is $10,000/20 = $500. This gives you an Edge Ratio of 500:167. To convert this to a simple ratio, divide the average winning value by the average losing value and ratio it to 1. Thus, 500/167=3 so the Edge Ratio is 3:1.
This means that on average the value of your winning trades is three times higher than the value of your losing trades.
The value of your Win/Loss Ratio and Edge Ratio in isolation is of little value. It is the combination of the two which is important. A trader can have a profitable business with a Win/Loss Ratio as little as 30%, as long as that trader is achieving a high enough Edge Ratio (in the vicinity of 4:1). Similarly, even if a trader achieves a very high Win/Loss Ratio, that trader can still lose money overall if they have very large losing trades and only small winning trades (ie a low Edge Ratio).
In the example above, we have a trader with a Hit Rate of 40% and an Edge Ratio of 3:1. Using the numbers in the example above, this resulted in a profit of $5,000.
So even though only 40% of the trades are winning trades, the overall trading is still profitable as the Edge Ratio is high. On the face of these statistics, you could say that this trader is good at keeping losses small and may wish to concentrate on their entry criteria to improve their Hit Rate.
If you have already started trading, take a sample of the last 10-50 trades, record the profit and loss on each trade and calculate all of the following statistics.
➢ Total Number of Trades:
➢ Number of Winning Trades:
➢ Number of Losing Trades:
➢ Total Value of Winning Trades:
➢ Total Value of Losing Trades:
➢ Hit Ratio:
➢ Edge Ratio:
What do these statistics tell you about your trading and what areas might you need to concentrate on?
This is for general informational purposes and does not take into account your objectives, financial situation or needs. For specific financial advice we recommend that you seek independent professional advice from a licenced financial adviser.