Five rules you must have for a winning trade
Having a trading plan is critical to your ongoing trading success. Last week I was invited to speak to a group in Asia, and share with them, the process and structure we use to identify and execute trades. Often it is good to take things back to the basics, and hence Five rules for a winning trade. The philosophy of the talk was “Keep It Simple and then Just Do It”.
Why five rules for a winning trade and not six?
The more complex and more layering that goes into a trading plan, the less likely the new trader is likely to follow all of the rules – missing one or two – and effectively then being totally out of control. As such, some simple foundations that work, are critical to your survival in the market. To give you an alternative perspective, one of my traders is an expert when it comes to Robot Trading development and his view is, if it takes more than 5 Rules, your system is unlikely to work effectively over time.
So here are 5 rules to help you along the way
1) You must have a view.
What is your view on the trade – are you bullish and think the position is going to go up. Are you bearish and believe it the instrument is going to fall away, are you neutral and believe the position is going to stay relatively flat or are you simply not sure? Any one of the above is a valid view to have – especially the last – “when in doubt, do nowt”, being a classic Yorkshire expression! However, it is critical you have a view – no view means no trade.
2) What is the basis of your view?
In other words how did you arrive at that conclusion or opinion? This really comes down to your analysis approach and the leg work behind the trade. To give you an idea, for a covered call trade, my analysis starts with a top down approach. What I mean by this, is what is my overall view on the economic factors that may influence the performance of the stock. For example, when looking at a resources play – say FMG, what are iron ore prices doing, and why? This is fundamental to this business and as such must be factored in before we really do anything. Alternatively, if looking at a play in retail, David Jones say, what is the consumer doing – is sentiment and spending trending positively or negatively, as this will likely have a major impact on the outlook for the business.
Often I find with students, the best test for your view and the basis behind it, is to sit down and explain the trade to someone else – your rationale, reasoning and opinion. If they sit and look back at you with a blank face, perhaps you are a little off the mark! This is exactly how our trading desk works – where each day we put forward our trading ideas, through our daily strategy meeting, and justify/explain each trade idea, providing a screen on trade quality.
3) Time to look at the charts!
Why only now, I hear you ask? Well by starting off with a fundamental view you have already screened out hundreds of non-interest charts. You may be down to a sector now, based on your view – and have maybe a half dozen prospects to consider. By starting with the charts, and looking at any trade, chances are after 10 or 12 charts, you will start to become numb to the patterns and opportunity when it presents itself. So my goal, when I get to the charting stage, is to be looking for some key patterns.
The overall trend, as well as support and resistance, being the big three to consider. From here, we can assess whether we are too early to the party, or whether there is similar interest across the market. That being the case, if my view is bullish, then some evidence of an uptrend would be good to see. Also where is the current price relative to its support and resistance levels? Ideally on a break of resistance, perhaps there should also be some strengthening in the volume, with a strong close – afterall, we want a genuine break out, not a fake out, if we are getting in. You will note that so far, we haven’t used any technical indicators.
All too often I see trader screens covered in 6,7 8 or more indicators and I shudder – this is a rookie error. More indicators does not mean a better trade! If you are to use a couple of indicators, make sure they are not all from the same family. For example oscillators – they will all be measuring much the same thing, so will all be doing the same thing and that is not extra confirmation. Less is more, as the actual decision is in the chart and in the price action on the chart, not in the indicators. I take the view if you can’t see it in the chart, it’s not there – indicators will simply convince you otherwise!
4) Where are your price points
Where are your price points – and by this I mean your entry, exit and stop loss. These are the critical three and should be decided upon prior to entry into the trade, not once you are in. The charts will certainly assist in selecting these levels and you should clearly mark them on the chart, to see if they actually look sensible (hint, your profit target should be realistic and your stop should be within your risk management plan.
For example, if your risk per trade is never to be more than say 5%, and yet 5% is above a support level or within the current volatility profile of the price action, odds are you are going to get stopped out, only to see the stock then move up. The long term consequences of this happening may be that next time you don’t have a stop on the trade (you are then writing your trading obituary!) So double check how this looks on the chart, before entering the trade. Does it looks sensible from a logical perspective?
5) Just do it!
What is the trigger for the trade? How are you getting into the trade – will it be right now, with an “at market” order or alternatively when the price of the stock hits a certain level (a limit order), or perhaps when doing a buy and write, for a combined price of stock less option premium?
The key thing here, is when all of your criteria for the trade are hit, then take the trade. Don’t pause, don’t wait another day, don’t procrastinate just do it. If you are at a position to place the trade, it already measures up with your (WRITTEN) Trading Plan, you have already checked the numbers etc and now is time to hit the button.
It is generally at this point that any deficiencies in the earlier work show up. For example, if short cuts were taken in the analysis stage, this may be reflected by a reluctance to squeeze the trigger etc. If the work has been done, hitting the button is easy as you should have faith and confidence in your trading plan!
So there you have it – in its simple form, the past 1100 words or so have outlined 5 rules for a winning trade. How many of them are you currently using? Write your plan out and build your confidence in it, afterall as a trader, we have the easiest job in the world – executing our trading plan perfectly each and every trade.
The work is in building the plan – do the work once, maintain it, build your confidence in it, and you can look forward to a long and lucrative career in the markets. Take a short cut, and the bleached bones of what could have been your trading career will be there for all to see.