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Template for a Simple Day Trading Strategy

Many new traders gravitate towards a simple day trading strategy because they want easy solutions to the market puzzle. But as they gain experience, they realize that simple strategies are rarely profitable out-of-the-box. Yet, most traders still look for simple trading strategies. Why?

Why do traders love simple trading strategies?

First, it is easy to get started with a straightforward strategy. Hence, it acts as a helpful launchpad for any day trader, especially if you’re just starting out.

More importantly, the most straightforward day trading strategy is also the most flexible and hence the most powerful in the hands of a seasoned trader.

If you look, it’s easy to find many simple day trading strategies, including the Trend Bar Failure strategy and this simple strategy using Bollinger Bands. These strategies are simple and easy to follow.

However, are they right for you? Do they provide the best foundation for you to build on?

Every trader is different, so we might find it tough to make other traders’ ideas work.

So, why not create your own simple day trading strategy?

In this guide, you’ll pick up a template for creating your own simple day trading strategy.

In particular, this simple day trading strategy template:

  • Covers the necessary parts of a robust pullback trading strategy;
  • Uses no more than two trading indicators; and
  • Allows you to include your favorite tools.

Practical simplicity is the result of sensible limitations.

This is why we limit ourselves to looking for pullback setups and to a maximum of two trading indicators.

Simple Day Trading Template For Trend Pullbacks

This is a basic template for trading intraday trends.

  1. Find the trend
  2. Define a retracement
  3. Establish your entry and exit rules

#1: Find the trend

First, find the trend. Keep it simple and choose only one trend-following tool to help you.

Suggested trend tools:

  • Moving average sloping up or price crossing above the moving average
  • MACD moving above the zero line
  • ADX crossing above 25
  • Trend lines (HH, HL, or LH, LL)
  • Oscillator indicators with a long look-back period (including stochastics, CCI, RSI)

The chart below shows the 5-minute bars of the ES futures market (S&P E-mini futures on CME).

It demonstrates how to use the simple moving average (SMA) slope to identify the market trend.

Chart showing how to identify the trend with SMA slope

  1. When the SMA slopes up, it indicates a bull trend. (The green background makes it easier to track the direction visually.)
  2. The following session gapped down and changed the direction of the SMA.

Having a systematic way to define the trend is essential, but always remember that the market can have no tradeable trends.

Learning to recognize when to step aside is an essential contributor to your trading edge.

#2: Define a retracement

Next, we wait for the trend to slow down and retrace before taking a trade.

Jumping onto a train while it is speeding can get you to your destination. It’s just, well, a little challenging to find ways to do it without getting hurt.

It’s the same for riding trends. We can hop onto the trend while it is blazing away. But we face the obstacle of setting stop-loss orders to protect ourselves.

This difficulty is not a deal-breaker if you are looking to ride a trend for the long run. However, day traders have limited profit potential within the day. Hence, we need precise stop-loss points to support our positive expectancy for our setups.

This is where a retracement is helpful. It helps us pinpoint when the trend is slowing down so that we can hop onto it with controlled risk.

Decide how you identify a retracement within the trend.

For instance, in the Holy Grail trading strategy, a retracement is when prices fall back to the moving average in a bull trend.

Here are a few suggested methods for identifying a pullback:

  1. Tests of a moving average
  2. Oscillator indicators (oversold or overbought levels)
  3. Tests of a trend line
  4. Test of an earlier swing low (for long trades) or swing high (for short trades)
  5. Price patterns like the three-bar pullback

For confirming a retracement, very often, price action alone is sufficient. So try to keep it simple.

Let’s zoom into the bull trend we saw in the previous ES intraday chart. It points out the different criteria you can use to filter for pullbacks.

Chart showing different ways of determining pullbacks

  1. Three consecutive bar lows mark a pullback.
  2. This test of the SMA is also a pullback. But in this case, the pullback was shallow and not as desirable for a pullback entry.
  3. As we are using the SMA slope as our trend basis, a momentary change of the SMA slope could also highlight a pullback.

Although there are many options for this part of the template, remember to keep things simple.

So, choose only one tool to help you with defining the retracement. (Yes, we might miss out on some trades because of how we define pullbacks, but that is a cost we pay for consistency.)

If you can use the same tool you chose in the first step, then congratulations, you are a champion minimalist trader.

#3: Establish entry and exit rules

A day trading strategy is not complete without specific entry and exit rules.

You must know precisely when to enter a position and when to exit so that you can act without hesitation when the opportunity arises—having specific rules also help to define our reward-to-risk ratio for each trade.

To keep things simple, let’s refrain from adding another indicator. Instead, try using the tools you have chosen from the earlier steps to trigger your entry.

Here are a few suggested entry methods (for long setups):

Once you’ve done the heavy lifting by confirming the trend and identifying the pullback, the exact entry is often easier than you expect.

Look at the chart below. It shows the simplest entry for each of the pullbacks we identified earlier.

What is the simplest entry method?

  • Place a buy stop order above the first bullish bar that forms after the pullback.

Chart showing the simplest entry method

  1. This is the first bullish bar after the bearish pullback. Place a buy stop order above its high, and the following bar would trigger it.
  2. Again, the first bullish bar after the pullback, as indicated by the test of the SMA.
  3. Dead simple. A bullish bar for our entry again.

The primary value of the entry method is the stop-loss it implies. Thus, when we use a bullish bar to enter, its bar low serves as a solid initial stop-loss level.

Beyond the stop-loss, we also need to prepare for taking profits.

Here are a few methods you can consider for profit-taking:

  • Bar patterns and candlestick patterns
  • The previous extreme of the trend (This is the most conservative option within the context of a trend pullback trade.)
  • Oscillator changing direction
  • Measured move

For more profit-taking methods, check out this guide.

A Simple Day Trading Strategy Example

Now, let’s put the three parts of the template together in an integrated example – one that works without any trading indicators.

This is a 3-minute chart of CL futures (Crude Oil on NYMEX).

Simple Day Trading Strategy - Trend Line Trading

  1. First, we used a trend line to connect swing pivots to define a bear trend.
  2. Then, we waited for a test of the trend line before looking for a continuation trade entry. This test confirmed a pullback that we were interested in.
  3. Paying attention to the price action, we observed a bearish Pin Bar which triggered our entry.
  4. Finally, as this pullback was relatively deep, the previous extreme low of the trend offered a solid reward-to-risk ratio.

Here, we used only one trading tool: the trend line—no trading indicators.

A simple price pattern for entry and a previous support level for the exit.

That’s it. Trade simply.

A Different Mindset To Building Trading Strategies

Once you understand the power of using a template like the one we went through, you’ll also appreciate a broader lesson that will change how you build your trading strategies.

Common questions running through a trader’s mind as we construct a trading strategy:

  • What indicators should I use?
  • When should I enter the market?
  • How do I know when to sell?

Instead of starting with these questions, begin by examining what you want to achieve.

Move away from a starting point like this:

  • I want to use moving averages and trade crossovers. Which lookback period works best? What timeframe should I trade?

Towards one like this:

  • I want to identify the trend and find a low-risk entry with a sensible exit that offers positive expectancy. How can I do that?

Instead of focusing on the tools and strategies, start with understanding your goals. What do you want to achieve? Once that is done, you will find it a lot easier to choose the right tools for the job.

This change in mindset is what our template process encourages here.

Finally, don’t use the template by randomly plugging in the parts and start trading.

The key here is to work the template into a consistent trading plan.

For instance, how you determine the market trend is related to how you find pullbacks and entries. Some tools have a natural synergy with one another. Some methods work better for you because of your experience.

The goal is to integrate these factors using the template to create a strategy that is simple and effective for you.

The article was first published on 31 December 2013 and updated on 12 August 2021.

Read more about Day Trading, Pullback Trading, Trading Trend

Sours: https://www.tradingsetupsreview.com/template-simple-day-trading-strategy/

Awesome Day Trading Strategies

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Day trading is all about getting in a rhythm.  Over time you will begin to identify day trading setups that consistently work for your trading style.

Whether you have a high win ratio or the average winning profit runs much greater than your losers, you just need to come out ahead.

Your trading style is what makes your market experience unique from everyone else’s.  This is where your background, fears, and beliefs all converge in how you view the market.  No matter how good the system or the day trading setups placed right before your eyes, if the system is counter to how you view the world, you will not make money.

One of the most popular trading systems of all-times is the Turtle Trading system.  The Turtles, as they have been affectionately called, were able to make 100s of millions of dollars trading commodities.  That’s right folks, 100s of millions of dollars, but did you know that some of the trainees in the program were let go.  Even though these folks received the same training as the other Turtles, some could not grasp the concept of allowing their profits to run.  It’s never about the system; it’s about you the trader.

Learn to Trade Stocks, Futures, and ETFs Risk-Free

In this article, we will cover 6 classic day trading setups you can use to trade the markets.  When I say classic, it means these setups would have worked in the 1980s and will continue to work well into the 2030s.

As you study each day trading setup, it’s important to remember you must find the one that matches your trading style the most, in order to have success.

#1 Day Trading Breakout

No matter if the market is trending or aimlessly floating sideways, there will always be breakouts in the morning.  A breakout is defined when a stock gaps up or down on high volume first thing on the open.  These types of moves are almost always related to a news event.

Day Trading Setups - Breakouts

Day Trading Breakout Rules

  1. Stock gaps up or down on high volume.
  2. Wait for a trading range to develop between 9:30 and 9:50.
  3. Buy or sell short the breakout of the morning range high/low sometime between 9:50 am and 10:10 am.
  4. Have a predetermined profit target for your position.  Your profit target should be in alignment with the volatility of the stock.
  5. You must have a stop loss order.  My personal stop is a maximum of 2% and I look to exit trades if they are not profitable once the 11 am time strikes.

You may be thinking what’s up with the time references?  Day trading is fast, so you only have a set amount of time to capitalize on each trade.  At 11 am the number of participants in the market drops off dramatically and you will find it very difficult to trade breakouts.  So, get in and out in a hurry; time is not on your side.

Trader Profile – Day Trading Breakout

  1. Expects quick returns
  2. Perceives volatility as their friend
  3. Able to make trading decisions in a matter of seconds
  4. Less concerned with riding the trend and more attracted to making quick profits before the trend reverses course

#2 Fade the Breakout

Your ability to accurately pre-screen a breakout will determine how often the stock will continue in the direction of the primary trend.  I have been able to successfully introduce the concept of volatility into my trading system which has greatly increased my overall win rate.

If you are just buying and selling any and every breakout, then your success rate will likely land around 50%.  So, the takeaway from this statistic is there are just as many failing breakouts as ones that will continue trending.

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I’m a firm believer you should profit off of the failed breakout attempts as well.

Fade the Gap

Fade the Breakout rules

  1. Stock gaps up or down on high volume.
  2. Wait for a trading range to develop between 9:30 and 9:45.
  3. If the stock gaps up, the first 15-minute range high cannot be breached.  Conversely, if the stock gaps down, the first 15-minute range low cannot be breached.
  4. Buy or sell the break of the trading range between 9:45 and 10:10 in the opposite direction of the gap.
  5. The profit target is the closure of the gap.
  6. Stop loss is below the high or low of the morning range, depending on the direction of the gap.

Trader Profile – Fade the Breakout

  1. Expects quick returns
  2. Perceives volatility as their friend
  3. Able to make trading decisions in a matter of seconds
  4. Enjoys the idea of going counter to the trend
  5. Loves to punish other traders that jump in a trade too soon

#3 Trading Ranges

Believe it or not, there are trading ranges that can develop intraday.  It’s hard for people to think of day trading in terms of ranges because most people assume day trading is some wild man’s game with flashing lights bouncing off the screen.

I personally could not make money trading ranges.  It’s not that ranges don’t work; they just didn’t work for me.  The slowness of the moves and the fact I had to trade with larger sums of money to achieve the same profits made me uneasy.  I would close trades well before they had time to develop. You may not have these issues, so review the trading range rules and see if you have found a match for your trading style.

Trading Range

Trading Ranges Rules

  1. Stocks volume should be light compared to the morning’s trading volume.
  2. Identify a discernible high low range between 9:30 am and 11:00 am.  This may not always correlate to the high low of the day; just make sure you have identified the primary range.
  3. Range should be a minimum of 1% from high to low.  This will give you enough profit to cover commissions and the inherent risk that comes with any trade.
  4. Open new positions between 11:00 am and 2:00 pm.
  5. Buy the low of the range and sell the high of the range.
  6. Profit target is again the high and low of the range.
  7. Stop Loss is relative to the size of the range.  A rule of thumb is you do not want to see the range exceeded by .20% of its value.  So, if a range is 2%, you do not want to see the stock move out of the range by more than .4%.

Trader Profile – Ranges

  1. Slow to react
  2. Likes to perform thorough analysis over the course of a few minutes to a few hours
  3. Views volatility as unwanted risk
  4. Seeks to limit risk by placing tight stops
  5. Gravitates towards a clear trading channel versus sloping lines and other geometric shapes
  6. Is okay with placing multiple trades for the same stock

#4 Late Day Breakout

At the end of the day around 2 pm the volatility picks up again in the market.  This is where traders return from lunch and are looking to enter or close positions in preparation for the next trading day.  This is a great trading opportunity for active traders as the high low ranges set earlier in the day are breached.

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Again, I only trade the mornings, largely because I will over trade if given the opportunity, but if you are a volatility trader after 2 pm is when you can get back into the game.

Day Trading Setups - Late Day Breakouts

Late Day Breakout Rules

  1. The stock exceeds the morning range with an increase in volume after 2 pm.
  2. The stock is able to clear the range by .2%.
  3. Profit target is the size of the move that preceded the trading range.
  4. Stop loss is the middle of the range.  This would imply the stock failed on the breakout attempt and is now falling back inside of the range from the morning.

Trader Profile – Late Day Breakout

  1. Slow to react
  2. Likes to perform thorough analysis over the course of a few minutes to a few hours
  3. Likes volatility
  4. Enjoys riding the trend into the close

#5 Trading the Flag

A flag is a classic technical analysis pattern that predates anyone reading this article.  If you are unfamiliar with the pattern it’s a sloping rectangular formation that occurs after a strong move.  The primary characteristics of the formation are an increase in volume with a sharp price move.  The stock then begins to consolidate in a range pattern that goes counter to the trend and volume completely dries up.

While I do not trade flags, I do like the fact the formation is soundly based on price and volume principles.

Flag Formation

Flag Rules

  1. Stock needs to breakout with high volume
  2. A sloping rectangular range will develop with a minimum of 4 candlesticks
  3. Open new positions on a breakout above or below the range
  4. The profit target is the same length as the move that preceded the flag formation
  5. Stops should be placed below the low of the range if going long and above the high of the range if going short

Trader Profile – Flags

  1. Less concerned with a particular time of day and more focused on trading the setup
  2. Likes to see a number of inside bars and consolidation patterns before a continuation move
  3. Enjoys riding the primary trend to profits, regardless if this takes a few minutes or a few hours
  4. Only looking to trade a stock once, in order to reap the rewards of the next major move

# 6 Triangles

I trade the Wyckoff method which calls for parallel trend channels and stays away from the head and shoulders patterns, diamond formations, and other complicated chart formations.  However, I would be re-missed if I did not touch on the concept of ascending and descending triangles. Like the flag formation, an ascending or descending triangle will develop after a strong move in a stock.  The part of the triangle formation I like the most is that the reactions are smaller and smaller each failed attempt at the breakout level.

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Funny enough when a trade goes against me, the ascending or descending triangle is the one formation that you can literally feel pulling away at your life.  If you are short, the stock fails at the high of the day, so you immediately feel relieved as the stock backs away.  This flash of hope is replaced by fear as the stock quickly turns back up again and does not break the previous low of the day.  This process goes on and on, for what feels like ages, and by the time the stock finally breaks out, you already knew you were toast two hours into the formation.

Ascending Triangle

Triangle Rules

  1. Stock needs to have a strong move with price and volume
  2. Once a high or low is set, each reaction from that swing point should become more shallow
  3. Buy or sell short the break of the daily range
  4. Place your stop below the last swing reaction if long and above the last swing if short
  5. Profit target is the length of the move that preceded the triangle formation

Trading Profile – Triangles

  1. Less concerned with a particular time of day and more focused on trading the setup
  2. Likes to see a number of inside bars and consolidation patterns on a chart
  3. Enjoys riding the primary trend to profits, regardless if this takes a few minutes or a few hours
  4. Only looking to trade a stock once, in order to reap the rewards of the next major move

Summary of Day Trading Setups

In this article, we covered 6 classic day trading setups.  I could have easily highlighted another dozen or so, but that would only expose one of the main problems confronting active traders.

There are just too many opportunities present in the market on any given day.

Your job is not to trade everything but only trade a limited few. Remember, it only takes mastery of one-day trading setup to make consistent profits in the market.

Do you have an idea of what type of day trading setup you should be trading?  If not, or if you are looking to refine your current trading methodology, try out our trading simulator built by and for active traders.  Learn to trade in a risk-free environment before placing your hard earned money in the market.

Good luck trading,

Al

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Keep Your Day Trading Simple: Here's How to Do It

"Keep your (day) trading simple."

It's logical advice, yet rarely does the one saying it explain how to keep it simple. With thousands of articles, indicators, strategies, and traders all saying something different, how do you reduce it all down to the bare minimum and keep it simple? Keeping your trading simple means following three steps, on every single trade—and only focusing on one step at a time.

Key Takeaways

  • To keep your day trading simple, you need a strategy that allows you to focus only on one factor at a time.
  • Your basic strategy should focus on your trade setup, the trigger, and evaluating the risk and reward—one at a time.
  • If you progress through these steps and don't make a trade, go back to step one and make adjustments.

3 Simple Steps

The Setup

To be an effective trader, you need a trade setup. In a sea of ever-changing conditions, you need to filter out all the non-relevant information on your chart. A setup is a precise set of conditions that must materialize to indicate a trade could happen. Every trader's setup will be different; say for example you only trade breakouts from triangle patterns in the first two hours of the trading day, or in the first hour after lunch. 

The triangle is your trade setup. When a triangle appears, it lets you know a trade could be imminent. Until the triangle appears, though, you're relaxed and focusing on nothing but finding triangle chart patterns. 

By having a setup, you keep your trading simple. You aren't concerned about whether the price falls, rallies, or what the news is saying. Until a triangle pattern appears (or whatever your specific trade setup is) you have nothing much to think about.

Until the setup occurs, you can't advance to the trade trigger.

The Trade Trigger

The best trade setups let you know in advance (at least slightly) what your entry point will be. Once a triangle chart pattern appears, you know that your entry will occur when the price breaks out of the triangle (if that's your trade trigger). A trade trigger is an event that occurs following a trade setup that lets you know it's time to enter a trade. If using an indicator, the trade trigger could be the exact moment the indicator passes through a particular level or crosses another indicator line.

Once step one has occurred, and you have a valid trade setup, you no longer question whether you have a valid trade setup—this was already decided. Once you've identified a trade setup, your only task is to isolate what the trade trigger is.

Risk/Reward Assessment

A setup has occurred, and you defined exactly where and when you will enter the trade. During each stage there's nothing else to think about—in the first stage you watch for setups, that is it; in the second stage, you define your entry point. With a setup in place, and a trade trigger pending, your next step is to determine if you take the trade or not.

If the potential reward based on the setup (and your research and testing) outweighs the risk, execute the trade when the trade trigger occurs. If the potential reward doesn't outweigh the risk, move back to step one and start looking for another setup.

Being aware of economic or company-specific news events is part of the risk/reward assessment. Since we can't know in advance how the market will react to an economic release, avoid taking (or being in) trades three minutes before or after a high-impact economic/company-specific data release. Check an economic calendar before the trading day begins, so you know the data release times. Block off those times on your charts, so you know not to take trades, leaving you to focus on each stage as it comes.

The Bottom Line

At any given moment during the trading day, there should be only one thing you're thinking about, and that one thing is dependent on which step you are on. All other information is irrelevant.

First, only focus on finding your trade setup. Once you've found a trade setup, only focus on finding where the trade trigger is. Once you know the trade trigger, you can determine where your stop-loss order and profit target will go. Based on the stop and target (or the win rate of the strategy) focus on whether you'll take the trade when the trade trigger occurs. If the trade makes sense, execute the trade at the trade trigger. If the trade doesn't make sense, move back to step one.

This is how you keep your trading simple in real time. It requires that you've done your homework, though. You need to have defined a trade setup, determined what a respectable risk/reward ratio is (and how you will establish your risk and reward) and it also means you have isolated a precise event which tells you when to get into trades.

Sours: https://www.thebalance.com/keep-your-day-trading-simple-here-s-how-to-do-it-1031073
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Only Make a Trade If It Passes This 5-Step Test

No matter which market you trade—stocks, forex, or futures—each second the markets are open provides an opportunity to trade. Yet not every second provides a high-probability trade. In a sea of nearly infinite possibilities, put each trade you consider through a five-step test so you'll only take trades that align with your trading plan and offer good profit potential for the risk being taken. Apply the test whether you're a day trader, 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 if a trade passes the test, telling you whether you should trade or not.

Key Takeaways

  • Regardless of your trading strategy, success relies on being disciplined, knowledgeable, and thorough.
  • Here, we go over five simple steps to carry out before undertaking any trade.
  • These involve understanding you strategy and plan, identifying opportunities to know your entry and exit targets, and knowing when to abandon a bad trade.

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

Step 1: The Trade Setup 

The setup is the basic conditions that need to be present in order to even consider a trade. For example, if you're a trend-following trader, then a 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 a trend 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, as well as the price being above a 200-day moving average. Your trade setup may be different, but you should make sure that conditions are favorable for the strategy being traded.

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 that tells you now is the time to trade. In Figure 1, the stock was moving in an uptrend for a the entire time, but some moments within that uptrend provide better trade opportunities than others.

Some traders like to buy on new highs after the price has ranged or pulled back. In this case, a trade trigger could be when the price rallies above the $122 resistance 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 a bullish engulfing pattern or to consolidate for several price bars and then break above the consolidation. Both of these are precise events that separate trading 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 that occur during this stock uptrend. What your exact trade trigger is depends on the trading strategy you are using. The first is a consolidation near support: The trade is triggered when the price moves above the high of the consolidation. Another possible trade trigger is a bullish engulfing pattern near support: A long is triggered when the bullish candle forms. The third trigger to buy is a rally to a new high price following a pullback or range. 

Before a trade is taken though, check to make sure the trade is worth taking. With a trade trigger, you always know where your entry point is in advance. For example, throughout July, a trader would know that a possible trade trigger is a rally above the June high. That provides time to check the 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 a stop-loss order. There are multiple ways to place a stop loss. For long trades, a stop loss is often placed just slightly below a recent swing low and for a short trade just slightly above a recent swing high.

Another method is called the Average True Range (ATR) stop loss; it involves placing the stop-loss order a certain distance from the entry price, based on volatility.

Figure 3. Long Trade Example with Stop Loss Placement

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

Step 4: The Price Target

You now know that 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 size of the 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 the top of the channel. 

In Figure 3, the EUR/USD triangle pattern is roughly 600 pips at its widest point. Added to the triangle breakout price, that provides a target of 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 profitable 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 you to extract profits from the market in a systematic (not random) manner.

Step 5: The Reward-to-Risk

Strive to take trades only where the profit potential is greater than 1.5 times the risk. For example, losing $100 if the price reaches your stop loss 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 ratio of 2.86:1 (or 600/210).

If using a trailing stop loss, you won't be able to calculate the reward-to-risk on the trade. However, when taking a trade, you should still consider if the profit 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 take the 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, ensuring that these trades provide good profit potential 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 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. 

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, and 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 that may affect your trading, and implement additional steps if required.

This may seem like a tedious process, yet once you know your strategy and get used to 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 effort.

Sours: https://www.investopedia.com/articles/active-trading/090415/only-take-trade-if-it-passes-5step-test.asp

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