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9/10/2015

OnlyTakeaTradeIfItPassesThis5StepTest

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


By Cory Mitchell

No matter which market you trade--stocks, forexor futures--each second the markets are open provide an opportunity to trade. Yet not ever
second provides a high probability trade. In a sea of nearly infinite possibilities, put each trade you considerthrough a five-step test so you'll
take trades which align with yourtrading
yourtrading plan and offer good profit potential for the risk being taken. Apply the test whether you're a
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 i
passes the test, telling youwhether you should trade or not.

STEP 1: THE TRADE SETUP

The setupmeans the basic conditions that need to be present in order to even consider a trade. For example, if you're a trend following trade
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
isn'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 higher swing highs and lows, and
price being above a 200-day moving average. Your trade setup may be different, butmake sure conditions are favorable for the strategy being
Figure 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--is present, then proceed to the next step.

STEP 2: THE TRADE TRIGGER

If your reason for trading is present, you still need a precise event which tells you now is the time to trade. In figure 1 the stock was moving i
uptrend for a the entire time, but some moments within that uptrend provide better trade opportunities than others.

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Some traders like to buy on new highs after the price has ranged or pulledback. In this case, a trade trigger could be when the price rallies ab
$122 resistance area in August.

Other traders like to buy during a pullback. In this case, when the price pullsback to support near $115, wait for the price to form a bullish en
pattern,, or to consolidate for several price bars and then break above the consolidation
pattern
consolidation.. Both of these are precise events which separate tradi
opportunities from the all the other price movements (which you don't have a strategy for).
Figure 2. Possible Trade Triggers in Uptrending Stock

Figure 2 shows three possible trade triggers which occur during this stock uptrend. What your exact trade trigger is depends on the trading st
you are using. The first is a consolidation near support; the trade is triggered when the price moves above the high of the consolidation. Anot
possibletrade trigger is a bullish engulfing pattern near support; a long is triggered when the bullish candle forms. The third trigger to buy is a
a new high price following a pullback or range
range.
.

Before a trade is taken though, check to make sure the trade is worth taking. With a trade trigger,
trigger, you always know where your entry point is
advance. For example, throughout July a trader would know a possible trade trigger is a rally above the June high. That provides time to chec
trade for validity, with steps three through five, before the trade is actually taken.

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 astop
astop loss order. There are multiple ways to place a stop loss. For long trades, a stop loss is often placed just slightly below a re
swing low,
low, and for a short trade just slightly above a recent swing high. Another method is called the Average True Range (ATR) stop
loss;itinvolves
loss
;itinvolves placing the stop loss order acertain distance from the entry price, based on volatility.(For more, see What types of investors
best-suited for stop loss orders?)
orders?)
Figure 3. Long Trade Example with Stop Loss Placement

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Establish where your stop loss will be. Once you know the entry and stop loss price you cancalculate
cancalculate the position sizefor
sizefor the trade.

STEP 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 profit potential.

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

In figure 3 the EUR/USD triangle pattern is roughly600 pips at its widest point. Added to the triangle breakout price, that provides a target o
1.1650. 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. A trailing stop loss can also be used to exit pro
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 y
extract profits from the market in asystematic (not random) manner.

STEP 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 your stop
means 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 a reward-to-risk r
2.86:1 (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 consider if the pro
potential 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 shouldn't tak
trade. Avoiding bad trades is just as important to success as participating in favorable ones.

OTHER 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 profit poten
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 maj
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 eve
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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,
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 th
affect your trading, and implement additional steps if required. This may seem like a long process, yet once you know your strategy and get u
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 e

2015, Investopedia, LLC.

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