No matter which market you trade, no matter if you’re a trader or investor, you need to pass this 5-step test for all trades to make sure that you’ll only take trades that align with your trading plan and offer good profit potential for the risk being taken
Step 1: Check Trade Setup Condition
The setup condition is the basic condition that need to meet in order to consider a trade. Think of the “setup” as your reason for trading.
For example:
- If you’re a trend following trader, a clearly trend appears can be a trade condition.
- If you’re a swing trader, an overbought or oversold signal appear can be a trade condition.
Your trading plan should define what’s your trade setup condition. It can be one or two or event three conditions depend on your strategy. You have to check if the current market stage meets all of your trade setup conditions before you start to think about a trade.
If this step is passed, continue to the next step.
Step 2: Find Entry Poin
When your trade condition is present, you still need to find a precise event that tells you it’s the time to enter. Here are an example about trade entry points:
- If you would like to use Support & Resistance as the trade condition, the entry point for a Buy trade is when it breaks a Resistance level. Some careful traders may choose the entry point is the time when the price goes back to test the resistance level (Now, it is a support level).
- If you are a swing trader who are using Bollinger+++ indicator, you will see that we also defined a safe entry point for Buy – Sell signals. These signals don’t appear when the Overbought – Oversold period is happening. They appear when that period is over and the price starts to revert to the mean price.
If this step is passed, continue to the next step.
Step 3: Determine Stop Loss Point
You have to take risk but you also have to do risk management in all trades. You will see that I usually talk about the risk first and the profit later.
There are many ways to determine a stop loss point. Many traders use recent swing slow as the stop loss for a Long/Buy trade and recent swing hight for Short/Sell trade. Other traders (including me) prefer another way to calculate stop loss based on volatility (ATR).
When you have the stop loss point, make sure you can accept this loss if your trade reaches the point. Otherwise, consider to reduce your trade volume or just simply stop this trade.
Stop Loss point isn’t easy to calculate and a stop loss order is hard to place. However, it is very very very important. All of your trades MUST HAVE a stop loss point.
If this step is passed, continue to the next step.
Step 4: Calculate Take Profit Point(s)
Now, we already have a reason to trade, a safe point to enter and an acceptable stop loss point, it’s time to think about profit.
A profit target is based on measurable factors, it’s not a randomly chosen. Normally, take profit point depends on the trade setup condition and also depend on your risk tolerance.
For example: Your choose the trade setup condition is chart pattern formed, the take profit point(s) in this case is based on the type and size of that pattern. You may use one take profit point to close your trade soon when it reaches your target. However, you may take more risk and use two take profit points to close 50% of your trade volume in each point to earn more profit (as the second point will generate more profit).
If this step is passed, continue to the next step.
Step 5: Measure Reward/Risk Ratio
When you have all Entry point, Stop Loss point and Take Profit point(s) you can calculate Reward/Risk Ratio eeasily.
For example: You would like to enter a Buy trade. Entry point is $100; Stop Loss point is $90; Take Profit point is $118. The Reward/Risk ratio is: ($118 – $100)/($100 – 90) = 1.8
If the potential profit is similar or lower than the risk, avoid the trade. This is trading, not gambling. I recomend you never trade if this ratio is under 1.5
Note: You can ignore fees if it’s too small in your trades. However, if you are a day trader and/or using large margin, please remember that trading fee is a big amount.
If this step is passed, start your trade.
Conclusion
Let’s do it! Just enter a trade if the 5-step test above is completed and passed. Whenever a step is not passed, don’t trade! You’ll have another opportunity that much better.
At first, this process takes some practice and many time. However, when 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.
This is a simple process that let you see if it is a good or bad trading oppotunity and you should enter or avoid it. I really surprised that many traders I have talk to didn’t know about something like this. So I would like to share this post to you.
Please also remember that we sell some indicators that you can use to find trade setup conditions or even help you calculate all trading points you need above.
Safe & Happy Trading!!!