5 Things To Check Off Before Every Trade
Too many times traders enter the financial markets with the wrong attitude towards trading. They often only think of how much money they could make if they just could hit that one home run trade. This kind of mind set, unfortunately, often leads to the trader taking much too large of a position, chasing a move higher, and all too often blowing up their accounts when the market inevitably goes against them. This, in turn, leads to thoughts of quitting trading, or "maybe trading isn't really for me". All of these things can be prevented and traders who trade for a living never let these things happen to them. If this sounds like you, then check out these 5 things that you should be checking off before you make each trade.
1. Identify Your Market Assumption
It does not matter what market you are trading. If you do not keep an overall broad market assumption, how can you know if you are taking a trade that is going against the momentum/direction of the market? I trade mainly options on stocks, so I like to use SPY for my market assumption because the SPY is considered the broad market and contains a good mix of each sector. Typically, if the SPY is trending up, I will look to go long or buy calls. If SPY is trending down, I will look to short or buy puts. There are other strategies that can be deployed, but that's a whole other post in itself. It doesn't really matter what you use to obtain your broad market assumption as long as you are using something that is relevant to the actual underlying or security that you are trading. For example, if you trade a lot of Tech, you might use the Nasdaq etf QQQ or the spdr technology sector etf XLK to obtain your market assumption for your tech trades. The idea is to be able to have the big picture so that you can trade in the path of least resistance and not be fighting momentum.
2. Define Your Setup
Every trader should have a "playbook" of setups that they use to find trades and enter trades. I'll use the analogy of a football offensive coordinator reading the defense. He has a whole playbook of plays that are designed to be deployed in certain situations. When he reads the defense, he knows exactly which kind of play to choose that will have the best chance of success in that particular situation. The offensive coordinator doesn't just send his offense out onto the field and let them wing it. At least not if he wants to have any chance to win. As a trader you need to treat your trades the same way. You have to have your setups defined and ready to deploy when you see them on the chart.
3. Define Your Risk
This may be the most fatal mistake that I see most traders make. They either define their risk too high or not at all. They usually don't even think about their risk until they're on the wrong side of the trade and it's going against them, draining their account because they traded too big. In my personal opinion, a trader should manage their risk at NO MORE than 5% of their account balance. Also, keep 50% of the account in cash. I know a lot of new traders start off with small accounts and they think that they can't make the kind of money that they see people making on Twitter and YouTube if they invest such a small amount of their account. NEWS FLASH: If you do not define and manage your risk responsibly, the market will turn against you at some point, and you will lose much more money than you are comfortable with. It can even ruin your life if you are not careful. Please, for the sake of your sanity and happiness, define and manage your risk.
4. Set Your Profit Target
So you've determined your market assumption, defined the setup that is being presented, and you have defined the amount of risk that you are going to allow for the trade. Now you need to develop a plan to exit the trade if it goes your way. A big thing I see out in the universe of financial education is the notion of "letting your winners ride". This can be a viable strategy, but you still have to have a plan to exit at some point or it can come right back against you and end up turning a winner into a loser, which is unacceptable to a profitable trader. Instead of "letting your winners ride", my personal opinion is that having a profit target in mind and taking regular profits when the market presents those opportunities makes a lot more sense. Also, it tends to transform winning from a feeling of "winning the jackpot" to more of a "collecting the royalty check" kind of feeling. If you win like someone "collecting a royalty check", you will find yourself collecting those profits much more often.
5. Journal Your Trade
The last step before you hit the send order button should be to journal your trade. Of course, this is only one part of the journal entry because the second part will be completed once the trade is closed. Journaling your trades is the best way to track your progress as a trader. If you do not do this vital step, you are coming to the market at a big disadvantage because you will have no real idea what actually works about your system. You cannot define your edge. Each journal entry should include some variation of the following:
profit / loss
% profit / loss
how you found it (scan, chat, twitter, uncle joe, etc.)
If you do these 5 things before ever entering every trade, you will be miles ahead of most traders. Do yourself a favor and start treating your trading like a business instead of a hobby. These 5 things will bring your trading to the next level and actually force you to think about what you are doing with your hard earned money before you just jump in and lose it. Plan your trade. Trade your plan.