Traders devote more effort to finding trading setups than to any other aspect of the trading business. This is a good thing insofar as a trading strategy with a positive Expectancy is essential for success. It is a bad thing if it so consumes the trader that the vital aspects of Expectancy testing and money management are neglected.
In this context, a trading strategy is defined as the collection of rules followed to determine when to enter a trade, how to manage the open trade, and how to exit from the trade. Some traders rely on intuition and experience in these matters, reacting to situations flexibly according to their market instincts. Not many succeed that way for long – the rest of us need carefully designed rules to guide our trading actions.
The Entry is triggered by a signal, typically the formation of a chart pattern or a change of state in one or more technical indicators. There are many technical indicators, normally divided into two classes – trend following indicators which give good signals in trending markets, and oscillators which are better in sideways (non-trending) markets. While you should certainly research technical indicators, I find it best to base day trading signals on simple chart patterns.
Entry signals are assessed for risk and some signals may be ignored because the risk/reward ratio is poor.
Trade management is a significant contributor to your overall success. Three aspects should be considered:
- Stop Loss management. All trades, without exception, must have a stop in place. A stop is not an absolute guarantee against catastrophic loss, but it provides a good measure of protection and is an essential aspect of trading discipline. The placement of the initial stop loss, and the manipulation of stop loss orders as a trade develops, must be implemented according to a set of predetermined rules.
- Exit Strategy. The trader must know in advance exactly how the trade will be closed. There are two ways of approaching this. One is to set a target and exit with a limit order if the market reaches that level. The other technique is to continuously adjust stop loss orders behind a market moving favourably, locking in greater profits with each adjustment. (This is referred to as a trailing stop loss order.) Eventually, the trade is stopped out when the trend move reverses.
- Multiple Contract Strategy. A trader does not have to enter every position at the same time, nor sell at the same time. Some traders acquire more contracts as a trade proves itself by moving in their favour. Others close contracts at different target levels to lock in partial profits.
A trade management plan is chosen on the basis of its performance during testing. Ensure the plan is not tested on data used to develop it, to avoid curve fitting. It should also be supported by a commonsense trading rationale. As in all aspects of trading, simple approaches work better.
