In Part 5 – What to expect…
The concepts behind successful trading are easy to understand, but the psychological challenges are more difficult to overcome. Why is it that trading, which seems to be easy, can frustrate even the most accomplished person?
The main reason is that we have to do many things that are in conflict with our usual way of thinking.
The reaction to take the peach and leave the banana is perfectly normal but the peach is your profit in the market and the banana is your loss. It is much easier to take the peach but at some point in time you have to take the banana, ideally before it gets worse. The longer you leave the banana, the worse it becomes, until you can no longer stand the smell, sight and feel of it. That is the point when the pain gets too much and the trader gives in, finally admitting they made a mistake. The peach should be left on the tree until it drops off by itself because too many traders are quick to grab a profit and end up missing out on the big win that would have turned around their whole year’s trading.
Our normal reactions that are programmed into us from birth onwards do not work well in a trading environment. It is essential to change these habits or ways of thinking to be a successful trader.
For most people new to the trading world a mechanically based strategy is easier to trade. Strict rules and a knowledge of the strategies historical success can lead to trading profits in the future. It is far easier to follow a clearly defined strategy than it is to make decisions based on the market feedback.
Reacting to market feedback will invariably lead to incorrect trading decisions. Plan the trade and then trade the plan.
A trading plan is made up of six key elements: Setup, Entry, Stop, Risk Management, Exit and Execution. All of these are required to achieve your trading goals. Each of these aspects are important to achieving a successful outcome in the markets. Developing a comprehensive plan allows a trader to use a machine like approach to the market.
I believe the setup is the most overlooked aspect of a trading plan. It is easy to be told take an entry signal when two lines cross over, but this will NOT work in all market environments. It is far more likely to work if the market is bullish, or the sector is strong, or the share is fundamentally undervalued. These are examples of setups that should be in place before entering a trade.
The key to any trades success is the development of a trend. The entry signals that are used should identify the start of a trend. Simple indicators like the moving average crossover, MACD cross, parabolic SAR or directional movement can be used to identify a change in trend and subsequently an entry point. In addition to this a trend change can be identified by the candlestick patterns, break of a trend line or support or resistance level which can also be used as entry signals. Any of these techniques will provide a suitable entry signal, but the key to profitable trading is to ensure that you have found a sound setup.
As discussed, when setting stops, one of the most important factors to consider is your initial dollar stop. Decide on an amount of capital to place at risk on each trade and on the appropriate placement of your stop and then calculate the position size to use. This approach is critical to your survival in the CFD market and ultimately to your profitability.
All trading strategies experience times when they do not work and times when they make money. Even buying shares randomly would show these characteristics. The key for the successful trader is to be able to survive the times when things are not working.
Decide first on your entry price based on your analysis, then follow that up with a decision on where to place your initial stop. Determine the amount of money you are prepared to lose if the trade goes wrong and then use this to determine your parcel size.
With a stop placed in the market it is possible to know what your risk is per contract that you enter. Based on the dollars you are prepared to risk, you can calculate your position size using the following formula:
Number of CFDs = capital at risk / (entry price – exit price)
Placement of a stop loss at a different level would result in a different position size: a tighter stop would allow a larger position and a wider stop would result in a smaller position.
So far we have only been considering what happens if the trade goes wrong. This is a vitally important consideration when trading, but I am in the market for the trade to go right. So how do you take profits when things do go your way. As with entries there are a variety of choices for exiting from a trade. A mechanical exit will generally work far better than a human decision as it removes the emotional attachment to the outcome.
The indicators used for entry above can all be used as exit signals. Moving averages tend to be slow to exit from a position, but do hold a trader in for the bigger trends by avoiding getting stopped out as the primary trend pulls back. The parabolic SAR tightens up the exit as the position moves more into profit.
Trailing stops are popular either based on a percentage below the entry price, a multiple of the ATR from the price or a count back strategy.
Chart patterns can also be used to exit a position utilising candles, trend lines and support and resistance levels. Deciding on an exit for the trade is another important decision to be made when trading. Different exits will be required for different types of trades and historical testing of different exits can be used to determine the most suitable exit for a particular trading strategy.
And last but not least is the execution of the strategy. There are different techniques for entering and exiting a trade. This could involve using specific types of orders; market, limit or stop orders or entering or exiting at different times of the day; market open or market close. Beware of limitations by different CFD providers on when orders can be placed, what type of order can be used and the time of the day. Also beware of opening gaps and slippage that can occur when executing orders. Slippage is the difference between the price you want to trade at and the price you actually trade at. This is one of the costs of trading and can have an impact on your trading results. Execution is about turning theory into reality and determining whether the strategy you have developed can actually be traded.
Coming up next…
[juiz_sps buttons=”facebook, twitter, google, digg, weibo, linkedin, stumbleupon, mail”]