Only Take a Trade if it Passes This 5 Step Test
No matter which market you trade – stocks, forex or futures – each second the markets are open provides an opportunity to trade. Yet not every second provides a high-probability trade. In a sea of nearly infinite possibilities, put each trade you consider through a five-step test so you'll only take trades that align with your trading plan and offer good profit potential for the risk being taken. Apply the test whether you're a day trader, swing trader or investor. At first it will take some practice, but once you become familiar with the process, it takes only a few seconds to see if a trade passes the test, telling you whether you should trade or not.
Step 1: The Trade Setup
The setup is the basic conditions that need to be present in order to even consider a trade. For example, if you're a trend-following trader, then a trend needs to be present. Your trading plan should define what a tradable trend is (for your strategy). This will help you avoid trading when a trend isn't there. Think of the "setup" as your reason for trading.
Figure 1 shows an example of this in action. The stock price is moving higher overall, as represented by the higher swing highs and lows, as well as the price being above a 200-day moving average. Your trade setup may be different, but you should make sure that conditions are favorable for the strategy being traded.
Fig1. Stock in Uptrend, Providing Possible Trade Setups for Trend Traders
If your reason for trading isn't present, don't trade. If your reason for trading – the setup – is present, then proceed to the next step.
Step 2: The Trade Trigger
If your reason for trading is present, you still need a precise event that tells you now is the time to trade. In Figure 1, the stock was moving in an uptrend for a the entire time, but some moments within that uptrend provide better trade opportunities than others.
Some traders like to buy on new highs after the price has ranged or pulled back. In this case, a trade trigger could be when the price rallies above the $122 resistance area in August.
Other traders like to buy during a pullback. In this case, when the price pulls back to support near $115, wait for the price to form a bullish engulfing pattern or to consolidate for several price bars and then break above the consolidation. Both of these are precise events that separate trading opportunities from the all the other price movements (which you don't have a strategy for).
Fig 2. Possible Trade Triggers in Uptrending Stock
Figure 2 shows three possible trade triggers that occur during this stock uptrend. What your exact trade trigger is depends on the trading strategy you are using. The first is a consolidation near support: The trade is triggered when the price moves above the high of the consolidation. Another possible trade trigger is a bullish engulfing pattern near support: A long is triggered when the bullish candle forms. The third trigger to buy is a rally to a new high price following a pullback or range.
Before a trade is taken though, check to make sure the trade is worth taking. With a trade trigger, you always know where your entry point is in advance. For example, throughout July, a trader would know that a possible trade trigger is a rally above the June high. That provides time to check the trade for validity, with steps three through five, before the trade is actually taken.