You don’t need to look to other traders, books, videos or courses to find a day trading strategy as with a bit of guidance you can develop day trading strategies of your own. One of the ways to journey into day trading strategy development is by using technical price or chart patterns. Price patterns are recurring themes you see day in and day out, which more often than not can lead to a certain defined outcome which you can capitalize on. Finding these pattern and ultimately developing a strategy for trading them will require five broad steps.
Most successful trade traders risk less than one or two percent of their account on each trade. Your first step in developing a strategy is assessing how much capital you’re willing to risk on each trade.
If you have a $40,000 trading account, and are willing to risk 0.5% of your capital on each trade, your maximum loss on each trade is $200 (0.005 X $40,000). Knowing this amount will help determine if the entry points and exit points you establish in the next two steps are feasible for the amount of money you’re willing to risk.
Entries only occur if the market produces a specific set of conditions which more often not can produce a favorable result for that entry point. To come up with Entry Rules, look over a tick chart, 1-minute and 5-minute (or other times frames in between). Look for large or trending moves where there was a great profit potential. Was there a candlestick pattern which initiated the move? Could an indicator have signaled an entry point? Is there an overall trend (longer-term chart) which provided confirmation of the signal? Are chart patterns present, such as a triangle, flag, pennant, or head and shoulders pattern? These are questions to consider when assessing how to enter a position.
Specifically define and write down the conditions under which you’ll enter a position. “Buy during uptrend” isn’t specific enough. “Buy when price breaks above the upper trendline of a triangle pattern, where the triangle was preceded by an uptrend (at least one higher swing swing highs and higher swing low before the triangle formed) on the 2-minute chart in the first two hours of the trading day.” This is must more specific and also testable (discussed later).
Once you’ve got a specific set of entry rules, scan through more charts to see if those conditions are generated each day (assuming you want to day trade everyday) and more often than not produce a price move in the anticipated direction. If so, you have a potential entry point for a strategy. You’ll then need to assess how to exit those trades.
At minimum a strategy must have a way to exit both winning and losing trades. A stop loss order controls risk. For long positions a stop loss can be placed below a recent low, or for short positions above a recent high. It can also be based on volatility, for example if a stock price is moving about $0.05 a minute, then you may place a stop loss $0.15 away from your entry in order to gives the price some space to fluctuate before hopefully moving in your anticipated direction. Define exactly how you will control the risk on the trades. In the case of a triangle pattern for example, a stop loss can be placed $0.02 below a recent swing low if buying a breakout, or $0.02 below the pattern. $0.02 is arbitrary, the point is simply to be specific.
There are multiple ways to exit a wining position, including trailing stops and profit targets. Profit targets are the most common exit method, taking a profit at a pre-determined level. Traditional analysis of chart patterns provides profit targets. For example the height of a triangle at the widest part is added to the breakout point of the triangle (for an upside breakout) providing a price to take profit at. The profit target should allow for more profit to be made on winning trades than is lost on losing trades. If your stop loss is $0.05 way from your entry price, your target should be more than $0.05 away.
Define exactly how you will exit your trades. The exit criteria must be specific enough to be repeatable and testable.
Decide what type of orders you will use to enter and exit trades. Will you use market or limit orders? Also define whether you must wait for a price bar to complete to trigger an entry or exit signal, or if you will take the signal in real-time when it occurs. In the triangle breakout example on the 2-minute chart, do you wait for the breakout bar to close above the triangle before entering, or do you enter as soon as the price crosses above the triangle trendline?
Tying it Together
Once you’ve defined how you enter trades and where you’ll place a stop loss, you can assess whether the potential strategy fits within your risk limit. If the strategy exposes you too much risk the strategy needs to altered in some way to reduce the risk.
If the strategy is within your risk limit, then testing begins. Manually go through historical charts finding your entries, noting whether your stop loss or target would have been hit. “Paper trade” in this way for at least 50 to 100 trades, note whether the strategy was profitable and if it meets your expectations. If so, proceed to trading the strategy in a demo account, in real-time. If it’s profitable over the course of two months or more in a simulated environment proceed with day trading the strategy with real capital. If the strategy isn’t profitable, start over.
A strategy doesn’t need to win all the time to be profitable. Many traders only win 50% to 60% of their trades, but make more on their winners than they lose on their losers. Make sure risk on each trade is limited to a specific percentage of the account, and that entry and exit methods are clearly defined and written down. The method should be so precise, that even if you don’t trade for a year you should be able to look at what you wrote down and know exactly what it means and what you have to do.
Cory Mitchell can be contacted at Vantage Point Trading