How was the scanning? Did you try it out? Did you practice scanning for specific items? This can seem somewhat daunting for some but it really does get easier the more you practice it. As you move through your trading journey you will most likely find that you scan less and less as you ill probably build a couple of watchlists that are your favorite and you may even find that these watchlists will produce more trade candidates than you have time, money or energy to take advantage of. This is completely ok because we are looking for quality setups, not quantity. As an experienced trader, I will tell you that a few great trades is all one needs to reach your modest trading goals. This goes back to the theory of letting our winners run and cutting our losers short. When you get hold of a “flyer”, that is a trade that just keeps going and going in your direction, you can, if you have set up the trade correctly and don’t try to overmanage the trade can make a large portion of profits from that one trade alone. Most novice traders don’t understand this and they feel the need to trade every set up they see. This is problematic for a few reasons. First, this increases our commission costs in a big way and secondly, it requires a lot more management of the trades and can get overwhelming for new traders that haven’t built up their trading systems and gotten comfortable managing their positions.
In this episode the Rookie Blog we are going to look at a sample watchlist of liquid stocks and look for a favorable setup, this goes back to the patterns from our technical analysis, we are looking for a pattern that is repeatable so that we can enter a trade with an edge and if we can find a pattern that tends to repeat then we can put ourselves on the right side to begin the trade with. This doesn’t mean that all our trades are going to work out but it does mean we are starting on the right foot.
When we find the above-mentioned pattern we are going to drill down some numbers that let us know if that trade works for us. A good looking pattern is not enough alone, we need other metrics in our favor and that is what we are going to go over during the next few weeks. At this point, we need to gather information and then we need to do some basic math to make sure what we are doing will actually work and I am not talking about just this trade I am talking about our entire system of trading.
Let me explain what I am referring to by looking at risk versus reward. Let’s say we do ten trades in a row and we win 5 and lose 5. If we win the same amount each time as we lose each time this series of ten trades should come out to break even, not including commissions. We are not in this game to breakeven as we have to overcome the cost of commissions and the bid/ask spread so we need to play a different type of game. There is another hitch in this scenario, are we good enough to win 5 times out of ten on a consistent basis? Some traders are and some traders are not, and the reality is most are not most of the time. We need to set ourselves up a trading system that gives us a favorable outcome even if we are wrong more than 50% percent of the time. Let’s say we can only be right 30% of the time, is it possible to still make money? The answer to that is yes as long as when we win we win enough. Look at the chart below to see how we would make out if we only took trades that paid us 3 to 1, meaning that when we lose we lose $1 and when we win we get $3.
You can see from the chart above that being right only 3 times out of ten and we can still be profitable. This becomes important because as I originally stated we are unlikely to be right on a consistent basis more than 50% of the time. So we need to not only find good setups on our charts but we need to find trades that can give us a risk-reward ratio that is consistent with our abilities. This is the first thing we need to derive and the way we do this is by setting up a good entry point and putting a target and a stop loss order in case we are wrong. This is called the SET principle. S stands for stop loss, E stands for entry and T stands for Target. If you look at the chart below you will see that I have put some lines on the chart where we would put all these things.
This is what we do for each trade we put on. We always must know when to get in, when to get out and how far the equity can potentially move. Next week we are going to go deep into how we came up with the numbers for our SET. Like all other aspects of trading we have rules that we must use and we will explore those rules and how it all ties together with risk and reward. So for this week take a look at your trades and see how often you are right and then take a look at the chart above and see what risk/reward ratio you would need to be profitable.
