There are numerous ways of approaching the market, but there are a few key factors which traders should know before they pull the trigger on a trade. Traders should ask themselves a few basic questions to ensure they are giving themselves the best possible chance.
1 – Is this a high-quality set-up; does it fit my trade criteria?
Over-trading is an easy trap to fall into, but by checking off the right boxes as to what qualifies as a good trade set-up each time before you enter the market, you can potentially avoid unnecessary losses. Avoiding a bad loss is considered a win; one less loss you have to make back.
Using a checklist, whether it be physical, digital, or mental can be an excellent way to keep you on the right track. It helps you ensure you are taking only those set-ups which fit the criteria in your game-plan.
2 – Where will I enter?
This question ties into question #1, but with a twist. Your set-ups are possible opportunities, but there are different ways to take advantage of those opportunities. If, for example, you are trading price levels; will you enter right at the price or wait for a reaction and utilize, say, a candlestick formation before entering?
Another example. Maybe you prefer to trade breakouts or pullbacks. There could be a large trading range forming, then a sudden breakout – some traders will buy the breakout, others will wait for a pullback following the breakout, or a combination of the two. This comes down to personal preference.
Will you scale in at various points as the market moves in a particular way? Multiple entries are a common way to enter and exit. In any event, know exactly how you want to enter.
3 – Where will I exit?
You need to know where you will exit if the trade moves for and against you; profit targets and stop-losses. This needs to be determined before you enter the trade, not after. Stop-losses should be based on the point where you are most likely proven wrong. For example, placing a stop sufficiently below support on a long-trade is logical.
If the trade is profitable, where will you exit – what is your target? For technical traders, this should be based on sound analysis. For example, if you are long, where are the next levels of resistance? If short, where are the next levels of support?
In either case – stop-loss and profit objectives – assigning fixed values is not prudent (i.e. – I will risk 'x' number of pips to make 'x' number). In this case, you are imposing your will on the market and not using logical levels based on analysis.
4 – What is my risk/reward based on questions 2 and 3?
Your risk/reward ratio is determined by the distance from entry to stop-loss and distance from entry to target. Again, this should be based on logical analysis. You want to look for asymmetrical opportunities where your reward significantly outweighs your risk.
A good rule of thumb is a risk/reward ratio of 1:2, but is dependent on your trading strategy. For example, traders who employ breakout or momentum strategies, the win/loss % will be lower, but the risk/reward profile will be larger. On the other hand, range-trading or mean-reversion strategies will have a much higher win/loss %, but with lower risk/reward ratios. In either case, you want to have a sufficiently positive skew between amount risked and potential gain.
5 – How much capital am I willing to risk?
Know your risk-tolerance and trade with position-sizing accordingly. This varies from trader to trader. It’s best to think about how much you will risk in terms of percentage of capital at risk per trade (i.e. 0.25%, 0.5%, 1%, 2%...) rather than straight leverage. Meaning, your position-size and leverage factor will be dynamic dependent on the distance from entry to stop-loss.
Position-size is also dependent on the time-frame and frequency in which you operate. For example, a swing-trader holding days to weeks can risk larger amounts given the low-frequency of trades than say, a day-trader, who may make numerous trades in a single session. In the later case, risking a far smaller amount is prudent as losses can add up very quickly.
6 – Do I have a high level of conviction; can I accept a loss?
This is the final question which needs to be answered without hesitation. Here you are trying to align the objective with the subjective. You should ‘feel good’, be confident, about the trade you are about to enter, thus giving you the best chance to properly manage the trade once the P&L starts moving around.
If you don’t have a proper level of conviction it will be easy to fall prey to careless mistakes due to a high level of uncertainty. These careless mistakes will lead to frustration, and frustration can breed more frustration. A vicious cycle you want to avoid.
For the full conversation, please see the video above…
Past recordings you might be interested in:Creating a Trading Plan; Handling Drawdowns; Risk Management; Analysis, keeping it simple; 6 Mistakes Traders Make; Focusing on the Process; Building Consistency; Classic Chart Patterns, Part I; Classic Chart Patterns, Part II
---Written by Paul Robinson, Market Analyst
To receive Paul’s analysis directly via email – SIGN UP HERE
You can follow Paul on Twitter at @PaulRobinsonFX