INVESTING in the stock market or any other financial market can be a daunting task. With so many variables to consider, it’s easy to get overwhelmed and end up making poor investment decisions. To avoid this, investors need to have a disciplined, knowledgeable, and thorough approach to trading. In this article, we explore a five-step test that can help you make informed decisions about whether to take a trade or not.
Step 1: The Trade Setup
The first step in the process is to identify the basic conditions that need to be present before considering a trade. For instance, if you’re a trend-following trader, you need to see a trend in place before making a trade. Your trading plan should define what a tradable trend looks like for your strategy. This helps you avoid trading when a trend isn’t there.
Step 2: The Trade Trigger
If the setup is present, you still need a precise event that tells you when to trade. This could be when the price rallies above a particular resistance area or when the price consolidates for several price bars and then breaks above the consolidation.
The exact trade trigger depends on the trading strategy you’re using.
Step 3: The Stop Loss
To manage the risk on your trade, you need to have a stop-loss order in place. This is an order that automatically exits the trade if the price moves against you. There are several ways to place a stop loss, but for long trades, it’s often placed just slightly below a recent swing low, and for a short trade, just slightly above a recent swing high.
Step 4: The Price Target
Once you’ve identified the entry point and stop loss, you need to consider the profit potential. A profit target should be based on something measurable and not just randomly chosen. Chart patterns, for example, provide targets based on the size of the pattern. Trend channels show where the price has had a tendency to reverse.
Step 5: The Reward-to-Risk Ratio
The final step is to determine if the reward potential is greater than the risk.
Strive to take trades only where the profit potential is greater than 1.5 times the risk. If the profit potential is similar to or lower than the risk, avoid the trade.
By following this five-step test, investors can avoid bad trades and only take trades that align with their trading plan and offer good profit potential for the risk being taken.
In addition to the five-step test, there are other considerations that investors should keep in mind. For instance, 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.
In conclusion, by applying the five-step test and considering other relevant factors, investors can make informed decisions about whether to take a trade or not. This approach can help them avoid bad trades and only take trades that align with their trading plan and offer good profit potential for the risk being taken.