To prevent this from happening too often, traders must develop a systematic approach that takes into account the environmental condition on every trade. The objective is to guide a trader into a better decision making process.
Trading Risk, Reward and Probability
The three main factors one must focus on as a trader are risk, reward and probability. In my experience as a trading instructor, the one factor that most traders struggle with is gaining a clear understanding of what determines the probability on a trade. In other words, based on the current market conditions, what are the odds the trade will work? Figuring out the risk on a trade seems to be the easiest part of the equation, while profit projections (reward) are another tough one and a topic for another article.
Let’s review two specific trade examples that transpired from my early morning sessions with trading students. In these two setups, charting the trading environment gave us different readings on the probability scale. This additional perspective allowed us to determine probability of the trade working out in our favor and to make better decisions in the examples that follow.
British Pound Trade Example
In the first scenario, we identified a buy area (demand zone) in the British Pound futures contract. The zone from a pattern perspective- looked good, but that’s only one piece of our trading process. The second piece is determining whether the Pound was near a larger time frame turning point or range-bound. As seen from the daily chart below, the trading environment at the time was a sideways pattern. This is a lower probability environment as the forces of supply and demand are more or less in equilibrium.
Source: Tradestation Technologies
I know some are thinking that at the time of this chart the Pound has been trending lower; however, when the momentum slows (as is the case in this trade example) this could portend a change in trend. Traders never know the trend has changed until after the fact, however. Looking a bit closer at the buy zone in the chart below, it can be seen that indeed price did pause at that level for several hours before buyers gave way to the sellers and stopped out. Looking at the current trading environment on the daily time frame could have given a trader pause to take this trade.
Source: Tradestation Technologies
Australian Dollar Trade Example
In the second scenario, we spotted a structurally sound (good looking pattern) supply in the Australian Dollar Futures contract, similar to the prior example. The main difference from our British Pound example was that the AD (Aussie Dollar futures) had been rallying into a major turning point, as seen on the daily chart below.
Source: Tradestation Technologies
In other words, this type of trading environment gives a much higher chance that the trade could turn out as the trader expected. This is mainly due to the fact that buyers thin out (demand decreases) as price moves higher in any market. Granted, there are never any guarantees in trading, but by using a supply and demand strategy and looking at the trading environment on the chart, the risk was reduced and this particular trade worked out pretty well for those traders that executed properly.
Source: Tradestation Technologies
In Summary
Markets are in a perpetual state of change and traders must always monitor and adapt to those changes. To this end, this tracking of the trading environment using charts should be an integral part of the process. I hope this helps in that regard.
Gabe Velazquez can be contacted on this link: Transparent Trading Solutions
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