Only Make 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 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. Use the ADX indicator to see if a trend is present and how strong or weak it may be. Think of the "setup" as your reason for trading.

Figure 1. Stock in Uptrend that appears to be failing. Bullish or Bearish?

The chart in Figure 1 shows Nvidia stock in an up-channel, giving us two potential setups. The first setup, is to go with the trend higher, where $240 looks to be the key daily resistance point and trigger for a continuation of the move higher. This bullish set-up would be activated on a daily close above $240; in this case, the trigger.

Of note, the recent gap higher was due to better than expected earnings, but more recent news suggests problems ahead. Namely the US government is considering banning the sales of NVDA's products to China based on national security concerns.

From a different perspective, this chart setup looks strikingly bearish, medium-term. A short would be triggered on a drop below the $230 area.

Further, the average directional index, or ADX, in the lower window shows that the trend has peaked, potentially signaling a reversal lower. In addition, recent prices have shown a bearish divergence relative to the S&P 500 as a whole (gold line), again suggesting an eventual move lower. Once again, NVDA has remained elevated, while the S&P 500 has taken a sharp downside move, suggesting that NVDA is also likely to decline on general market weakness.

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 the chart above, the stock was moving in an uptrend in recent weeks, but has recently stalled and begun to consolidate in a sideways pattern, while still remaining in the up channel.

In this case, a trade trigger for a long position would be when the price rallies and closes above the $240 resistance area in March. On the downside, the trigger for a short is a break below the up channel, currently around $230 and rising sharply.

Other potential short-trade triggers can be found by looking out for a bearish crossover of the Ichimoku's Tenkan line (fast moving. average) and Kijun line (slower moving average). Another negative signal is apparent in the bearishly diverging ADX (the bottom window), which failed to match recent new highs and is currently declining, suggesting the trend is weakening and may be ending.

Step 3: The Stop Loss

Having the right conditions for entry and knowing your trade trigger isn't enough to produce a good trade. The risk on that trade must also be managed with a stop-loss order. There are multiple ways to place a stop loss. For long trades, a stop loss is often placed just slightly below a recent swing low and for a short trade just slightly above a recent swing high.

In Figure 2, we can see IBM has been in a broad sideways range between roughly $120/150 for more than a year. The current decline is showing signs of a parabolic move lower. We would also note that the RSI is moving lower, but is well above oversold conditions, so it has more room to go lower. That suggests a short position at current market levels around $125, with a buy stop close by at the down trendline around $130.

We can't emphasize enough the importance of a stop loss to cover any position. It's what keeps small losses from becoming large losses. Establish where your stop loss will be. Once you know the entry and stop loss price, you can calculate the position size for the trade.

Step 4: The Price Target

You have now found that conditions are favorable for a trade, as well as where the entry point and stop loss will go. Next, consider the profit potential. 

A profit target is based on something measurable and not just randomly chosen. Chart patterns provide targets based on the size of the pattern. Trend channels show where the price has had a tendency to reverse; if buying near the bottom of the channel, set a price target near the top of the channel, for example. 

Establish where your profit target will be based on the tendencies of the market you're trading. A trailing stop loss can also be used to exit profitable trades. If using a trailing stop loss, you won't know your profit potential in advance. That is fine, though, because the trailing stop loss allows you to extract profits from the market in a systematic (not random) manner until the market reverses.

Step 5: The Reward-to-Risk

Strive to take trades only where the profit potential is greater than 1.5 times the risk. For example, losing $100 if the price reaches your stop loss means you should be making $150 or more if the target price is reached. 

If using a trailing stop loss, you won't be able to calculate the reward-to-risk on the trade; the market will do that for you. However, when taking a trade, you should still consider if the profit potential is likely to outweigh the risk.

If the profit potential is similar to or lower than the risk, by all means avoid the trade. That may mean doing all this work only to realize you shouldn't take the trade. Avoiding bad trades is just as important to success as participating in favorable ones. You don't have to be in the market all the time, just when the pieces laid out above come together.

Putting It Together

The five-step test acts as a filter so that you're only taking trades that align with your strategy, ensuring that these trades provide good profit potential relative to the risk. Add in other steps to suit your trading style. For example, day traders may wish to avoid taking positions right before major economic numbers or a company's earnings are released. In this case, to take a trade, check the economic calendar and make sure no such events are scheduled for while you're likely to be in the trade. 

The Bottom Line

Make sure conditions are suitable for trading a particular strategy. Set a trigger that tells you now is the time to act. Set a stop loss and target, and then determine if the reward outweighs the risk. If it does, take the trade; if it doesn't, look for a better opportunity. Consider other factors that may affect your trading, and implement additional steps if required.

This may seem like a tedious process, yet once you know your strategy and get used to the steps, it should take only a few seconds to run through the entire list. Making sure each trade taken passes the five-step test is worth the effort.

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