A conversation with a trader should not go like this: “Hey, went short the EUR and made 50 tics.”
“That’s great, what prompted the short?”
“Just liked it....”
At this point in the conversation, you should leave the room, remove any money under management you have with this person, and run like crazy for the front door. To paraphrase Talem, this trader is “fooled by randomness.” If a trader cannot tell you why he made the trade he did, for whatever reason, then sooner or later his position will be blown up and his guts will be hanging off the wall.
A trader should have a trading plan and should follow it: Plan the trade, and trade the plan. Trading plans prevent emotional trading. A trader should know four things before entering a trade: where to get in the market, why to enter there, where to take profits and when to stop losses. The “why” of the trade is more important then making money, especially with beginning traders. The “why,” if properly managed and followed, will allow a trader to ride a good trade and promptly cut off a bad trade. A good “why” is a good trading plan.
Trading consists of extended periods of inactivity punctuated by brief periods of frenzied action. Traders make mistakes during the waiting periods as they talk themselves into trades just so they aren’t sitting idle.
A trading plan not only forces the trader to answer the “why” of the trade; the plan gives the trader permission to wait. Many beginner mistakes are due to the belief that inactivity implies laziness.
When putting together a trading plan, which can take the form of successive “if/then” statements, the trader first must have a view on the direction of the market (see “Follow the Formula,” below). Which charts to use at which times generally depends on the trader’s view of the market and the duration of the trade. A good choice for swing trading is the four-hour and one-day charts, and day trading might call for a five-minute and four-hour setup.
For trend analysis on the five-minute day-trading chart we can compare the 10-period exponential moving average (EMA) against the 20-period EMA. The strategy is if the 10-period EMA is above the 20-period EMA (10 > 20), then the trader is looking to go long the market. If the 20-period EMA is above the 10-period EMA, then the trader is looking to go short the market. (See “Moving target,” below.).
With the 10-period above the 20-period, the trader goes long with the trend. The steeper the trend, the farther apart the EMAs are and the better the entrance point for the trader.
When the signals are not perfectly clear, the trader should stand aside. Technical analysis relies on having the crowd react to the general technical pattern. The clearer the pattern, the faster the crowd should react, and the more true-to-form the reaction will be. Therefore, in this simple trading plan, the trend is identified by moving averages, which point to the direction of the trade.
A key to the trading plan is a common addendum to the “if/then” statement: the “unless” statement (see “Follow the formula,” (above).
What if the trader were looking to enter the trade at entrance point “B” in “Moving target”? Entering the long at point “B” is not as obvious a winning trade as point “A” as the EMAs have flattened out and trading in the market looks a little channel-like rather than trending. It is not so obvious that the market will continue to trend. The trader always has three options: long, short or wait. The trader should wait for a clear indication that the market will continue to move up, or to reverse.
The “unless” statement is used to encompass additional technical indicators, options barriers and fundamental news that may dictate a specific action or inaction. This could even involve trading against the trend. Trading against the trend is inherently more risky and not advisable unless the trader sees clear signals that the trend is going to reverse.
There are several types of reversal signals. These are classified under Western technicals, Eastern technicals, fundamental data and options barriers. These four areas support the “unless” statements of a simple trading plan.
The most obvious of Western indicators are double tops (“M”), double bottoms (“W”), and support and resistance numbers as shown by cycles and Fibonacci retracements. “About to turn” (above) shows a classic double top. This double top is extremely clear and would prompt other traders to reject the prevailing trend and short the market.
It’s critical that any execution wait for both tops to occur. Remember that the “unless” statement means that the trader will be trading against the trend. Therefore, the “unless” should be perfectly clear and obvious. If the trader has to ask himself whether it is really a reversal pattern, meaning it isn’t clear and obvious, then no trade should be taken.
Candlesticks are also particularly useful for defining the end of one trend and the beginning of another. Candlesticks (Eastern Technical analysis) do not point to the direction of a trend, but rather are used as entry and exit points for an existing trade or a trend-changing trade. If the trader waits for the trends to cross before exiting a position, he may be giving up valuable profits as the trend consolidates and changes. Candlestick analysis allows the trader to exit gracefully and profitability from his trade.
In “Bullish indicator” (above), the trader would exit any short position or enter a long position, even against the trend, after the morning star candlestick pattern signals an uptrend. The key to using candlesticks to trade against the trend is using solid confirmation signals.
Accordingly, if the trader sees a morning star pattern, he should not enter the market until after the next candlestick after the morning start pattern confirms an upward price movement.
The “unless” statement of the trading plan also should consider support and resistance information, especially that pertaining to Fibonacci numbers. In the daily chart of the euro (see “Retrace my day,” below), note that the price action has been oscillating around the 38% retracement from the top of the move (April/May), but now has hit the 38% support level (price retracement from the top of the move).
Fibonaccis often provides support and resistance to price moves. The trader may consider ending a swing short and waiting to see if the trade bounces off the Fibonacci support line. Support lines do not necessarily mean to go long, but they do imply that the savvy trader probably should not automatically short at the support nor go long at the resistance level.
The savvy trader also should keep an eye on the news outlook of the market he is trading. Fibonacci resistance levels often fall into line with news and analysis on the market, which means that the crowd is all watching the same data and hopefully the market will technically react as expected.
“Unless” statements also encompass the fundamentals and can push the market to continue or change the trend. Often the technicals lead the fundamentals; however, betting on economic releases based on technical conditions is not advised. Review “Ahead of the curve” (above), which is the Oct. 17, 2006, trading action in the euro just before and after the producer price index (PPI) numbers were announced. The PPI report was expected to come out weaker overall, and slightly stronger on consensus. In fact, the main report was significantly weaker, but the core was significantly stronger than expected.
The market whipped downward on the stronger PPI data, which would be expected, but then whipped upward as the traders failed to take out the 38% retracement price support. Instead of trading on the more dollar positive core PPI data, the market traded on the weaker euro positive overall data. Do not bet on the data; wait for the crowd to decide the trend and then trade it.
Once the market shook out the economic data, the euro uptrend appeared. The key here is not to be blind-sided by economic news. It is amazing how many beginning traders do not follow the news releases religiously.
Options are also an important part of the “unless” statement. Some news packages have news plug-ins that report option barrier and option protection news. For example, a filing might report that a certain level, say 1.2550, is being protected as an option expires, so it would have been unfortunate to go long, even if the trend is positive, around 1.2550.
You should be able to diagram your plan in a flow diagram (see “Step by step,” below). If you cannot diagram the plan, then the plan has a logic problem. Similarly, if you are never entering positions or if you are always trading regardless of market conditions, then the plan has a logic problem.
Think of the plan as a simple computer program. The program could be set up as a series of if/then/else statements. Each input would take you to the next screen until you either enter a position or get brought back to the first screen because you should wait for a better entry position.
After the plan is written, half of the battle is won. The second half of the battle is keeping your plan handy while trading. Remember, the goal is to take the emotion out of the trade. You should keep records of the transactions made by following the plan.
Keeping a trading diary, which is another element of a well-thought-out trading plan, will help you stay honest to your plan. So, unlike the trader at the beginning of this article, when you’re asked why you entered a position, the answer will not be “just liked it....”, but rather, “I planned it!”
Leslie K. McNew is a clinical professor of finance and the director of the trading center at the AB Freeman School of Business, Tulane University, New Orleans. James Michael Purcell, Alton Ingram and Evan Fielman contributed to this article.