As we come to the end of the year, I thought it would offer value to my readers by posting an article I wrote a while ago.
Pertinent to any market condition, this article should make you think, “Duh!”
Who likes losing money trading? The obvious answer should be “nobody”-but from what I read and hear, people lose lots of money. In fact, too many traders lose way more money than they make. Either they have really deep pockets, only remember the good trades and neglect to read their P and L’s, fear success more than failure-or-simply lack a game plan and strategy to adhere to. I’m going with the latter.
Before one establishes a trade, there are 5 simple rules to follow:
Know what the Market Trend is as well as what the market indicators are saying-the phase of the market, McClellan Oscillators, Volatility Index, etc. It is important to trade with the trend, or at least know that you are not. Equally important is to know the trend of the sector and group you are trading.
Decide the timeframe of your trade.Is this a day trade, miniswing or swing trade? Not only should this decision be determined by the considerations in the first rule, but also how the moving averages of the particular instrument you are tracking line up. Where is the price point in relation to the 10,50 and 200 day moving averages? Where is the price in relation to the weekly moving averages? Are the moving averages stacked and sloped? What is the overall chart pattern?
Once you know the timeframe of your trade- establish the risk/reward accordingly.Basic guidelines I like to use are: day trade 1:1, 2:1 better; miniswing trade 3:1 and swing trade 5:1. If you can’t see my way to those targets based on that risk, pass on that trade.
Exercise flexibility when the trade is working and discipline when the trade is losing.Let’s put some teeth on that statement. You buy IWM for a day trade. Your risk is $.60 (about 1/3 of the average true range) and you expect to take off at least as much-maybe $1.20 as the market is also ticking up that day. But, instead of going up, the stock begins to fall. Now, you say to yourself, “Maybe I should make this a swing trade”? So you decide to risk more-say around 1 ATR. Okay-the ETF begins to fall- at some point, you’re down $1.00-now it goes back up to where you’re up $.50. You take a profit and thank your lucky stars. Was that good? No, no, no. Continue trading like that and you will not have a long career for sure, especially if it hadn’t rallied at all-you’re a big loser on what should have been a small risk. Here’s the opposite scenario. You bought IWM for a day trade. Your risk is the same, $.60. It rallies, it goes up $1.20-you take off at least 1/2 and decide to stick to see if there’s more follow through. You raise your stop on the balance so you can’t lose on the trade. Was that good? Yes, yes, yes. You will make money as a trader. In other words, it’s not about how often you are right, but how much you lose in comparison to how much you make.
Use the appropriate position sizing and money management.As you are mastering the 4 rules above, probably the single most important rule is this. Once you have figured out your timeframe, risk, reward, you must settle on a consistent percentage of your equity you are willing to lose on every trade and buy or sell shares accordingly. Come up with a number you are comfortable with and stick with it. For example, if your equity threshold is not losing more than $500 on any given trade-adjust the position sizing. Then, if you are consistently making money and playing with profits, you can begin to increase the position size. If you are losing, reduce the size. Makes sense, but only if traders actually do this consistently and dutifully.
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