Only Take a Trade if It Passes This 5-Step Test

8/17/2019 Only Take a Trade if It Passes This 5-Step Test

1/4

9/10/2015 Only Take a Tr ade If It Passes This 5-Step Test

http://www.investopedia.com/articles/active-trading/090415/only-take-trade-if-it-passes-5step-test.asp?utm_source=basics&utm_medium=email&utm_campai…

No matter which market you trade--stocks, forex or futures--each second the markets are open provide an opportunity to trade. Yeo matter which market you trade--stocks, forex or futures--each second the markets are open provide an opportunity to trade. Ye

second provides aecond provides a high probability igh prob bility trade. In a sea of nearly infinite possibilities, put each trade you consider through a five-step testrade. In a sea of nearly infinite possibilities, put each trade you consider through a five-step tes

take trades which align with yourake trades which align with your trading planrading plan and offer good profit potential for the risk being taken. Apply the test whether you'rand offer good profit potential for the risk being taken. Apply the test whether you'r

swing traderwing trader or investor. At first it will take some practice, but once you become familiar with the process it takes only a few seconor investor. At first it will take some practice, but once you become familiar with the process it takes only a few secon

passes the test, telling you whether you should trade or not.asses the test, telling you whether you should trade or not.

STEP 1: THE TRADE SETUPTEP 1: THE TRADE SETUP

The setup means the basic conditions that need to be present in order to even consider a trade. For example, if you're ahe setup means the basic conditions that need to be present in order to even consider a trade. For example, if you're a trend followrend follow

trend needs to be present. Your trading plan should define what a tradable trend is (for your strategy). This will help you avoid trarend needs to be present. Your trading plan should define what a tradable trend is (for your strategy). This will help you avoid tra

isn't there. Think of the "setup" as your reason for trading.sn't there. Think of the "setup" as your reason for trading.

Figure 1 shows an example of this in action. The stock price is moving higher overall, as represented by the higherigure 1 shows an example of this in action. The stock price is moving higher overall, as represented by the higher swing highswing highs andandprice being above a 200-day moving average. Your trade setup may be different, but make sure conditions are favorable for the strarice being above a 200-day moving average. Your trade setup may be different, but make sure conditions are favorable for the stra

Figure 1. Stock in Uptrend, Providing Possible Trade Setups for Trend Tradersigure 1. Stock in Uptrend, Providing Possible Trade Setups for Trend Traders

If your reason for trading isn't present, don't trade. If your reason for trading--the setup--f your reason for trading isn't present, don't trade. If your reason for trading--the setup--is s present, then proceed to the next step.present, then proceed to the next step.

STEP 2: THE TRADE TRIGGERTEP 2: THE TRADE TRIGGER

If your reason for trading is present, you still need a precise event which tells youf your reason for trading is present, you still need a precise event which tells you now ow is the time to trade. In figure 1 the stock wais the time to trade. In figure 1 the stock wa

uptrend for a the entire time, but some moments within that uptrend provide better trade opportunities than others.ptrend for a the entire time, but some moments within that uptrend provide better trade opportunities than others.

Only Take a Trade If It Passes This 5-Step Testnly Take a Trade If It Passes This 5 Step TestByy Cory Mitchellory Mitchell

http://www.investopedia.com/terms/r/rangeboundtrading.asphttp://www.investopedia.com/terms/s/swinghigh.asphttp://www.investopedia.com/terms/s/swinghigh.asphttp://www.investopedia.com/terms/s/swingtrading.asphttp://www.investopedia.com/terms/s/swingtrading.asphttp://www.investopedia.com/contributors/335/http://www.investopedia.com/terms/r/rangeboundtrading.asphttp://www.investopedia.com/terms/s/swinghigh.asphttp://www.investopedia.com/terms/t/trendtrading.asphttp://www.investopedia.com/terms/s/swingtrading.asphttp://www.investopedia.com/articles/trading/04/042104.asp


2/4

9/10/2015 Only Take a Trade If It Passes This 5-Step Test


Some traders like to buy on new highs after the price hasome traders like to buy on new highs after the price has rangedanged or pulled back. In this case, a trade trigger could be when the priceor pulled back. In this case, a trade trigger could be when the price

$122122 resistanceesistance area in August.area in August.

Other traders like to buy during a pullback. In this case, when the price pulls back to support near $115, wait for the price to form ather traders like to buy during a pullback. In this case, when the price pulls back to support near $115, wait for the price to form a

patternattern, or to consolidate for several price bars and then break above theor to consolidate for several price bars and then break above the consolidationonsolidation. Both of these are precise events which sepBoth of these are precise events which sep

opportunities from the all the other price movements (which you don't have a strategy for).pportunities from the all the other price movements (which you don't have a strategy for).

Figure 2. Possible Trade Triggers in Uptrending Stockigure 2. Possible Trade Triggers in Uptrending Stock

Figure 2 shows three possible trade triggers which occur during this stock uptrend. Whatigure 2 shows three possible trade triggers which occur during this stock uptrend. What your our exact trade trigger is depends on theexact trade trigger is depends on the

you are using. The first is a consolidation near support; the trade is triggered when the price moves above the high of the consolidaou are using. The first is a consolidation near support; the trade is triggered when the price moves above the high of the consolida

possible trade trigger is a bullish engulfing pattern near support; aossible trade trigger is a bullish engulfing pattern near support; a longong is triggered when the bullish candle forms. The third triggeris triggered when the bullish candle forms. The third trigger

a new high price following anew high price following a pullbackullback oror rangeange.

Before a trade is taken though, check to make sure the trade isefore a trade is taken though, check to make sure the trade is worth orth taking. With ataking. With a trade triggerrade trigger, you always know where your entyou always know where your ent

advance. For example, throughout July a trader would know a possible trade trigger is a rally above the June high. That provides timdvance. For example, throughout July a trader would know a possible trade trigger is a rally above the June high. That provides tim

trade for validity, with steps three through five, before the trade is actually taken.rade for validity, with steps three through five, before the trade is actually taken.

STEP 3: THE STOP LOSSTEP 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 maving the right conditions for entry and knowing your trade trigger isn't enough to produce a good trade. The risk on that trade m

managed with aanaged with a stop losstop loss order. There are multiple ways to place a stop loss. For long trades, a stop loss is often placed just slightlyorder. There are multiple ways to place a stop loss. For long trades, a stop loss is often placed just slightly

swing lowwing low, and for a short trade just slightly above a recent swing high. Another method is called theand for a short trade just slightly above a recent swing high. Another method is called the Average True Range (ATR) stverage True Range (ATR) st

lossoss; it involves placing the stop loss order a certain distance from the entry price, based on volatility. (For more, seeit involves placing the stop loss order a certain distance from the entry price, based on volatility. (For more, see What types ohat types o

best-suited for stop loss orders?est-suited for stop loss orders?)

Figure 3. Long Trade Example with Stop Loss Placementigure 3. Long Trade Example with Stop Loss Placement

http://external.investopedia.com/node/171048http://www.investopedia.com/articles/trading/06/stopplacement.asphttp://www.investopedia.com/terms/s/swinglow.asphttp://www.investopedia.com/terms/s/stop-lossorder.asphttp://www.investopedia.com/terms/t/trade-trigger.asphttp://www.investopedia.com/terms/r/range.asphttp://www.investopedia.com/terms/p/pullback.asphttp://www.investopedia.com/terms/l/long.asphttp://www.investopedia.com/terms/c/consolidation.asphttp://www.investopedia.com/terms/b/bullishengulfingpattern.asphttp://www.investopedia.com/terms/r/resistance.asphttp://www.investopedia.com/terms/r/rangeboundtrading.asp


3/4



Establish where your stop loss will be. Once you know the entry and stop loss price you canstablish where your stop loss will be. Once you know the entry and stop loss price you can calculate the position sizealculate the position size for the tradefor the trade

STEP 4: THE PRICE TARGETTEP 4: THE PRICE TARGET

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

A profit target is based on something measurable, and not just randomly chosen. Chart patterns, for example, provide targets basedprofit target is based on something measurable, and not just randomly chosen. Chart patterns, for example, provide targets based

pattern.attern. Trend channelsrend channels show where the price has had a tendency to reverse; if buying near the bottom of the channel set a price tashow where the price has had a tendency to reverse; if buying near the bottom of the channel set a price ta

of the channel.f the channel.

In figure 3 then figure 3 the EUR/USDUR/USD triangle pattern is roughly 600triangle pattern is roughly 600 pipsips at its widest point. Added to the triangle breakout price, that providesat its widest point. Added to the triangle breakout price, that provides1.1650. If trading a triangle breakout strategy, that is where the target to exit the trade (at a profit) is placed..1650. If trading a triangle breakout strategy, that is where the target to exit the trade (at a profit) is placed.

Establish where your profit target will be based on the tendencies of the market you're trading. Astablish where your profit target will be based on the tendencies of the market you're trading. A trailing stop lossrailing stop loss can also be usedcan also be used

trades. If using a trailing stop loss, you won't know your profit potential in advance. That is fine though, because the trailing stop lorades. If using a trailing stop loss, you won't know your profit potential in advance. That is fine though, because the trailing stop lo

extract profits from the market in a systematic (not random) manner.xtract profits from the market in a systematic (not random) manner.

STEP 5: THE REWARD-TO-RISKTEP 5: THE REWARD-TO-RISK

Strive to only take trades where the profit potential is greater than 1.5 times the risk. For example, losing $100 if the price reaches trive to only take trades where the profit potential is greater than 1.5 times the risk. For example, losing $100 if the price reaches

means you should be making $150 or more if the target price is reached.eans you should be making $150 or more if the target price is reached.

In figure 3 the the risk is 210 pips (difference between entry price and stop loss), but the profit potential is 600 pips. That's an figure 3 the the risk is 210 pips (difference between entry price and stop loss), but the profit potential is 600 pips. That's a rewarewar

2.86:1 (calculated by dividing 600 by 210)..86:1 (calculated by dividing 600 by 210).

If using a trailing stop loss, you won't be able to calculate the reward-to-risk on the trade. When taking a trade though, still considef using a trailing stop loss, you won't be able to calculate the reward-to-risk on the trade. When taking a trade though, still conside

potential is likely to outweigh the risk.otential is likely to outweigh the risk.

If the profit potential is similar to, or lower, than the risk, avoid the trade. That may mean doing all this work only to realize you shf the profit potential is similar to, or lower, than the risk, avoid the trade. That may mean doing all this work only to realize you sh

trade. Avoiding bad trades is just as important to success as participating in favorable ones.rade. Avoiding bad trades is just as important to success as participating in favorable ones.

OTHER CONSIDERATIONSTHER CONSIDERATIONS

The five-step test acts as a filter so that you're only taking trades that align with your strategy, and that these trades provide good phe five-step test acts as a filter so that you're only taking trades that align with your strategy, and that these trades provide good p

relative to the risk. Add in other steps to suit your trading style. For example, day traders may wish to avoid taking positions right elative to the risk. Add in other steps to suit your trading style. For example, day traders may wish to avoid taking positions right b

economic numbers or a company's earnings are released. In this case, to take a trade check theconomic numbers or a company's earnings are released. In this case, to take a trade check the economic calendarconomic calendar and make sure nand make sure n

http://www.investopedia.com/terms/e/economic-calendar.asphttp://www.investopedia.com/terms/r/riskrewardratio.asphttp://www.investopedia.com/terms/t/trailingstop.asphttp://www.investopedia.com/terms/p/pip.asphttp://www.investopedia.com/forex/pairs/eurusd/http://www.investopedia.com/terms/a/ascendingchannel.asphttp://www.investopedia.com/articles/trading/09/determine-position-size.asp


4/4



© 2015, Investopedia, LLC. 2015 Investopedia LLC.

scheduled for while you're likely to be in the trade.cheduled for while you're likely to be in the trade.

THE BOTTOM LINEHE BOTTOM LINE

Make sure conditions are suitable for trading a particular strategy. Set a trigger that tells youake sure conditions are suitable for trading a particular strategy. Set a trigger that tells you now ow is the time to act. Set a stop loss ais the time to act. Set a stop loss a

then determine if the reward outweighs the risk. If it does, take the trade; if it doesn't, look for a better opportunity. Consider othehen determine if the reward outweighs the risk. If it does, take the trade; if it doesn't, look for a better opportunity. Consider other

affect your trading, and implement additional steps if required. This may seem like a long process, yet once you know your strategyffect your trading, and implement additional steps if required. This may seem like a long process, yet once you know your strategy

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 whe 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 w

Date post:	06-Jul-2018
Category:	Documents
Upload:	iki-jit
View:	218 times
Download:	0 times

Only Take a Trade if It Passes This 5-Step Test

Documents