Only Take a Trade If It Passes This 5-Step Test

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Only Take a Trade If It Passes This 5-Step Test

No matter whatever market you trade—stocks, forex,or futures—each second the markets are open presents a chance to trade. However, not every second offers a high-probability transaction. In a sea of virtually endless options, put each trade you considerthrough a five-step test so you’ll only accept trades that line with yourtrading strategy and give significant reward potential for the risk being taken. Apply the test whether you’re a day trader, swing trader or investment.

It will take some practice at first, but once you get the hang of it, it just takes a few seconds to check whether a trade passes the test, indicating whether you should trade or not.

Key Takeaways

  • Whatever your trading technique, success is dependent on being disciplined, informed, and thorough.
  • Here, we go through five easy measures to take before engaging in any deal.
  • Understanding your strategy and plan, spotting chances to know your entry and exit objectives, and knowing when to leave a poor trade are all part of it.

Only Take A Trade If It Passes This 5-Step Test

Step 1: The Trade Setup

The setup refers to the fundamental conditions that must be met before considering a transaction. If you’re a trend-following trader, for example, a trend must be present. A tradable trend should be defined in your trading plan (for your strategy).This will assist you in avoiding trading when there is no trend. Consider the “setup” to be your motivation for trading.

Figure 1 illustrates this in action. Overall, the stock price is rising, as seen by greater swing highs and lows, as well as the price being above a 200-day moving average. Your trade setup may change, but you should ensure that the trading circumstances are beneficial for the method being used.

Figure 1. Stock in Uptrend, Providing Possible Trade Setups for Trend Traders

Image by Sabrina Jiang © Investopedia2020

Don’t trade if your purpose for trading isn’t present. If your trade reason—the setup—is there, go on to the next stage.

Step 2: The Trade Trigger

Even if your cause for trading is there, you still need a specific occurrence to indicate that it is now time to trade. The stock in Figure 1 was in an uptrend the whole period, but certain points within that uptrend provided better trading opportunities than others.

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Some traders like to purchase at new highs following a price range or pullback. A trade trigger in this situation may be when the price rises over the $122 resistance level in August.

Other traders like to purchase on a decline. In this situation, as the price falls to support around $115, wait for a bullish engulfing pattern to emerge or for the price to consolidate for several price bars before breaking above the consolidation. Both of these are specific occurrences that distinguish trading opportunities from all other market changes (for which you do not have a strategy).

Figure 2. Possible Trade Triggers in Uptrending Stock

Image by Sabrina Jiang © Investopedia2020

Figure 2 depicts three probable trading triggers during this stock upswing. Your particular trade trigger is determined by the trading method you choose. The first is a near-support consolidation: When the price goes above the high of the consolidation, the trade is activated. A bullish engulfing pattern near support is another probable trade trigger: When a bullish candle develops, Along is activated. A rise to a new high price after a pullback or range is the third buy trigger.

However, before engaging in a deal, ensure that the trade is worthwhile. You always know where your entry point is using a trade trigger. For example, a trader would be aware that a rise over the June high is a likely trade trigger throughout July. This allows time to evaluate the transaction for legitimacy using steps three through five before proceeding with the deal.

Step 3: The Stop Loss

Knowing your trade trigger and having the correct entry circumstances aren’t enough to make a successful trade. That trade’s risk must also be controlled using a stop-loss order. A stop loss may be placed in a variety of ways. A stop loss is often put just slightly below a recent swing low for long trades and just slightly above a recent swing high for short bets.

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Another strategy is the Average True Range (ATR) stop loss, which includes putting the stop-loss order at a certain distance from the entry price depending on volatility.

Figure 3. Long Trade Example with Stop Loss Placement

Image by Sabrina Jiang © Investopedia2020

Determine the location of your stop loss. You can compute the position size for the trade after you have the entry and stop loss prices.

Step 4: The Price Target

You now know that the circumstances are ideal for a trade, as well as the entry and stop loss points. Consider the profit possibility next.

A profit objective is based on something quantifiable rather than being picked at random. Chart patterns, for example, give goals depending on pattern size. Trend channels indicate price reversals; if purchasing around the bottom of the channel, establish a price goal towards the top of the channel.

The EUR/USD triangle formation in Figure 3 is 600 pips wide at its widest point. When the triangle breakout price is included, the objective is 1.1650. If you’re using a triangle breakout strategy, that’s where you want to exit the trade (at a profit).

Determine your profit objective depending on the trends of the market you’re trading in. Profitable trades may also be exited using a trailing stop loss. You won’t know your profit potential if you choose a trailing stop loss. That is great, since the trailing stop loss enables you to profit from the market in a systematic (rather than random) way.

Step 5: The Reward-to-Risk

Strive to enter trades only when the profit possibility exceeds 1.5 times the risk. For example, if the price hits your stop loss, you should make $150 or more if the goal price is met.

The risk in Figure 3 is 210 pips (the difference between the entry price and the stop loss), while the profit potential is 600 pips. This corresponds to a reward-to-risk ratio of 2.86:1 (or 600/210).

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You won’t be able to assess the reward-to-risk on the transaction if you use a trailing stop loss. However, before entering a trade, you should determine if the reward potential outweighs the danger.

Avoid the trade if the profit potential is equal to or less than the risk. That might entail putting in all of this effort just to learn you shouldn’t accept the exchange. Avoiding poor deals is equally as vital as partaking in good ones.

Other Considerations

The five-step process functions as a filter, ensuring that you only take trades that line with your strategy and have strong return potential compared to risk. Other stages might be added to fit your trading style. Day traders, for example, may want to avoid taking positions immediately before key economic data or a company’s profits are announced. In this situation, before entering a trade, check the economic calendar to ensure that no such events are planned during the time you’re likely to be in the trade.

The Bottom Line

Check if the circumstances are adequate for trading a certain strategy. Set a trigger that alerts you when it is time to act. Set a stop loss and a goal, then assess if the gain exceeds the risk. If so, accept the transaction; if not, hunt for a better opportunity. Consider other elements that may have an impact on your trade and take further precautions if necessary.

This may seem to be a time-consuming procedure, but if you know your plan and are comfortable with the stages, it should only take a few seconds to go through the full list. Making certain that each deal passes the five-step criteria is worthwhile.

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