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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.


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.


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.


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.


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.


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.

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.

Are we ready for our next trade?? We should be…..


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