TRADER'S NOTEBOOK

Seven Steps To A Good Trade

03/04/03 04:22:49 PM PST
by Paul Lange

It pays to follow a disciplined trading system.

Removing emotion and staying objective are two of the keys to achieving and
maintaining success in trading. Here are seven steps that you can review and adapt
to your own needs for executing trades. These steps apply to long-term trades as
well as daytrades. While they are intended for technically oriented traders, the list
can be quickly adapted to any style. Each of these steps could be the basis for an
entire article, but this outline should provide traders with a framework from which to
work:
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, thetimingof 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.