These three things are the most important parts of your trading whether you acknowledge it or not. This piece will trump everything I have written before this in the level of importance, even though those things are very necessary and give you more of an edge, this is an absolute necessity to building wealth and maximizing profits consciously so you can be consistent in the long term. Again, like the previous piece this is more of the art of trading or rather very personalized especially when getting into trade management but I can tell you how I do things, the basic outline of what you should be researching, and really give you a foundation of how to build your trade plan by giving you the things you should seriously put focus on. If you are really serious about this, and willing to put in the 10,000 hours the least I can do is push you in the right direction so you don’t get caught up jumping from strategy to strategy paying “educators” to teach you something that you have to learn for yourself anyway. That is what this whole education section is based on. This post is going to be a rather long one because of its importance, but those who are serious about trading and don’t have a grasp around it yet, don’t know exactly how to formulate a trade plan, or just understand that good traders never stop learning will take the time to read it. If you just map out a trade plan using the layout I am about to explain, you are already so much farther ahead of the majority than you even realize.
Probabilities:
“In poker, it’s not about winning every hand. Many top poker players every time fold their cards until they get the cards where they are waiting for. Top players also limit their losses by folding their cards more often. It is better to keep your stack intact, then throwing all the chips in the pot every time and hoping that you will pick the right card on the river. You’ll have to stick to the basic rules before you start thinking of playing a new and more complex strategy.”
Why would the top poker players in the world fold every time until they get the cards they want? Because they want the probabilities, and when they get those probabilities they capitalize as much as possible on those probabilities they were waiting on. It is no different in trading. How often do you sit back and wait for something within your guidelines to appear? What is the probability that the specific trade setup you are about to take is going to work over a large sample size? What are the probabilities that this trade is likely to meet or exceed your reward parameters over a large sample size? What are the probabilities that this trade will have any follow through at all so you can at least implement the first step of trade management, reducing your risk, over a large sample size? What are the probabilities of holding your stop loss, are the long term probabilities of that trade good enough that if you don’t hold the stop and the setup remains true, you would enter a second time on another attempt? A third time? Have you thought about any of this? Have you been running statistics or following mentally/back testing the probabilities of your trades over a long period of time? Notice how I keep saying over a large sample size or in the long term, because if you don’t focus on that very important part then you are completely missing out on the concept of probabilities. The probability of one trade working out is just a coin toss, it is one random pick out of your long term trade plan. The probability of that one random pick should still be good, but that doesn’t mean the market will honor that probability that time around. Specifically for intraday trading, what are the probabilities of the overall session reaching point B while price is trading at point A over a large sample size? What is the probable outcome of price trading above point A in the long term? These are things you need to research using the market price action and I will go into detail of each one of these below.
Statistics & Experience:
Typically people will use either experience or statistics generated from a computer algorithm or a mixture of both to make sure the probabilities are on their side. I personally did more manual back testing and studying live markets because that is just my nature and algos don’t adjust to changing market conditions unless the programmer changes the inputs, I would rather just know what I should be doing. Some people (usually traders with a programming background) will build an algorithm, look at the results, and replicate those results either manually or just straight through the algorithm. People will have algos running on simulated accounts for months before using live money so they can make sure they have the probabilities. When I was back testing for myself, I would go back to contracts being traded 10 years before, 5 years before, etc. to see if the market held the same constants. For stocks, I would go back and study the personality of that stock during trends since its IPO to see how that stock reacted to specific setups/trend support levels. What ever you do, the probabilities have to be on your side and you have to know it. What is good about studying the market directly is that your mind will take away information from the market that fits to your trading personality, which is something I discovered after studying it for a year or so and at the same time vendor jumping. While you are still in the process of finding out, use a simulator. There is no reason for you to loose a bunch of money when you don’t even know if you have a long term edge. Another thing, I have already given you a massive short cut by writing all the other education pieces! Multiple time frames, understanding trend analysis, market pressure/structure/location, key levels, all these things drastically increase the probabilities when you know how to use them correctly & together no matter what time frame you are trying to trade which is why it is basically pointless for me to try to go into examples on this topic.
Sessions & Long term directions:
Starting out with individual sessions for intraday traders. As an example, recently I switched over from using daily, weekly, and monthly pivot points to 5 minute open range with extensions. Why did I do that? If it ain’t broke, don’t fix it right? The 5 minute open range provided something that pivot points didn’t, probability expectations. What the pivots gave me was just some mathematical support and resistance levels that are widely used for tracking intraday price. That really doesn’t do much to give me expectations of where price action is going, just support and resistance. There is also no way to statistically track the probabilities of where price is going. To clear that up, the first thing I did before I even switched over to the 5m open range concept was run an algo through my platform to tell me how often price hits these extensions after trading outside of the open range. Here they are - Crude Oil, Russell 2000, S&P-500. Now, just by looking at those charts I can see how high the probabilities are of price at least hitting the first target (whether to upside or downside) much less the second, third, fourth, or even fifth. Pivot points were not able to give me these kinds of statistics, so in the past I was just doing trend trading which worked well for the most part but I didn’t have any statistical facts of where price was heading to, I would just trail my stops according to the probabilities of it holding (based on experience) as long as price was trending lower and higher until I was taken out. I won’t sit here and act like I know of 5 other ways of getting these kind of objective expectations and I don’t need to because this works. The point is you need something like this to guide you through the session to further increase your probabilities. This is the same reason I use a VWAP. I know that if price is above the VWAP by itself (without open range) there is a higher probability of trending higher, combining that with the open range my probabilities increase further and I have expectations of where price is heading to.
For long term direction or position trades it is already well documented. Go read “The Components of a Trend” “Using Multiple Time Frames for Day and Swing Trading” and "Using Relative Performance to Trade Professionally" and you will see how I calculate the probabilities of how price is going to perform in the long term by gauging how price reacts to my trend setup and key levels across time frames. Again, I won’t act like I know how to get this kind of information 5 different ways. The point is I know the probabilities, they are on my side, and it is something I need to know when determining if the trade fits into my long term trade plan.
Entries:
The most important thing about entries as far as probabilities go is that you have to use the law of large numbers, meaning you cannot put emphasis on any one trade but rather over a week, month, year of trades. It is also your choice of how high you want to set the bar for your probabilities. Just because you are using the law of large numbers, doesn’t mean you have to give up your high probability bar you have set for yourself. You will just have to take all the trades that meet that requirement you have set (and back tested) for yourself. I have a very high standard for the trades I take, but I know other traders that are profitable that have a much lower standard for trades and they take a lot more trades than I do. Neither way is ‘correct’, it is just how your personality is and what your goals are. This also means that once you start, if you don’t take every trade that you have back tested, studied, set the probability standard, etc. then you are messing up your probabilities of profitability. For example, say you just started taking the trades that you have mapped out for yourself and you take three losers in a row. The psychological aspect of trading is alive and well at this point and you say “screw this, this system sucks I need to start over” or whatever goes through your mind to make you stop. The next trade comes along and you pass on it, but this one would have wiped out all three losers and put you at a net profit for the day, possibly even for the week depending on how large the move. This is assuming that you have a good entry system of course while using good risk/reward & trade management. I am sure the point is very clear though, there are no probabilities in picking and choosing which trades you take. That is why it is so crucial to trade on a simulator for a while until you are sure you are competent to go live, but I will talk more about that at the end. For me, entry signals are just a confirmation of the directional probabilities I already know about that specific session or long-term stock trend as well as a green light of when to enter.
Risk/Reward:
"You cannot survive without that intangible quality we call heart. The mark of a top player is not how much he wins when he is winning but how he handles his losses. If you win for thirty days in a row, that makes no difference if on the thirty-first you have a bad night, go crazy, and throw it all away."
This quote makes a very good point relating to risk/reward, it does not matter how much money you win if you can’t keep it. As traders, we handle that by using risk/reward ratio and percentage risk. Understand it does matter how much you win when you are winning, that part of the quote I don’t agree with. You do need to take it to the bank though, you need insurance to make sure you are capable of taking a series of trades without your account dying from a few losses. There are two kinds of risk you need to be aware of and factor into your trade plan; percentage of your account, and risk to reward ratio. These two intertwine with each other because your maximum percentage risk is going to determine what your maximum risk can be in your risk/reward ratio. The risk aspect is much more objective than probabilities and management, but still a personalized part of the trade plan given your risk tolerance, account size, goals, and market conditions.
Percentage:
You have to know how much you are able to risk in each trade in order to come up with an appropriate risk/reward ratio so that you are able to absorb multiple losses in a row without it affecting your psychology or your actual account. You need to be here for the long term if you are going to make it. The classic percentage traders risk is the 1% rule; never risk more than 1% of your account in any trade. I think it is ok to go to 2% and sometimes even 3% depending on the probability of the trade. So if I am trading on a $10,000 account and I only want to risk 2% per trade that would come out to $200 of risk per trade max (10,000 x .02 = 200). If you were risking 2% you would have to take 50 losses in a row for your account to go to $0, at 1% it would be 100 losses in a row. Obviously your account is going to change as you win or loose money. I keep funds available in a side account so that if anything drastic ever happens I have money to refill it and get back on the horse. I also empty the profits out each month to restart with my initial balance so the dollar amount of my capital percentage always stays the same. Another way you could handle this is give yourself a benchmark to recalculate the percentage every time a certain amount of money comes in or out of your account. Say that number is $2,500 on your $10,000 account. At $10,000 risking 2% you can risk $200. Let’s say you make $2,500 and now your account is at $12,500. Since that is your benchmark you would recalculate your percentage to your new max risk which would now be $250 per trade (12,500 x .02 = 250). You do it again at $15,000, now your max risk is $300 per trade and if you are using a 10 tick stop at $10 per tick you can now add another contract (although I would wait for another $2,500 before doing that personally). You can see how this is giving you a framework to build your account and your trade plan in a methodical manner.
Ratio:
Everyone knows about the risk/reward ratio but just in case you don’t it is the ratio of how much your are going to risk on your trade compared with how much minimum you are looking to make on your trade (ex. Risk – $100 Potential Reward – $500 Expressed as 5:1 R/R). What I have found over the years is people don’t use it in conjunction with the percentage of your account or at least they don’t stress the importance of it. If you don’t do that you can have a 5:1 R/R but still be taking an extremely high risk trade if it is 10% of your account at risk. Another thing about R/R ratios is that for them to be effective, you have to hold for the entire reward or have a system you follow that locks in profits when your trade is invalidated like a trailing stop. This is why it is so important to know the probabilities of how far the market is going to move in a given time period, that way you can have a realistic potential reward while knowing the long term probabilities are in your favor while you are holding the trade. The larger your risk/reward ratio is, the larger your profitability will be and the higher your probability of success will be. For example, if you are taking 1:1 R/R all day this means you have to have a accuracy rate of over 50% (probably 60% with commissions). For every 1 loser, you have to make 1 winner to breakeven and that is excluding commissions. Even with a 2:1 R/R you have to make 1 winner for every 2 losers, that may sound great until you are actually trading and you aren’t very experienced and even if you are experienced you won’t be building wealth like that. Go ask the scalpers for yourself how much wealth they have built up. The market is so full of opportunity there is no reason you shouldn’t be trading 5:1 even 6-7-8:1, hell 10:1 sometimes. Sometimes I will be taking a trade that I know if it gets going there is such a high probability that I will be getting 100 ticks out of it, I will take the entry more than once if I get stopped out because I know that if I can get committed into a trade that has a high probability of producing 100 ticks, there will be chances for me to add while never risking more than my initial entry. That is my favorite scenario right there, the possibility of pulling out 60-80 ticks on double or even triple the size of my initial entry while never risking more than my initial entry.
Going back to the percentage paragraph with the $200 max risk on a $10,000 account. If you take a trade with a 3:1 initial R/R ($600:$200), you are keeping in bounds with your max risk percentage and you have to make sure you do that at all times. But if you have already risked $200 and you take your profits at $150, you have just turned a 3:1 R/R into a 0.75:1 R/R and that is not how you stay in this business for long. If you think you can hold a better stop loss than that say a 10 tick stop (-$100) you have now doubled your R/R to 6:1 ($600:$100). Maybe if that trade is extremely high probability AND you think you can hold a 10 tick stop you could put on another contract and still be in bounds with your max risk percentage ($1,200:$200). The point is, with a bit of experience you can have discretion and have what I call a ‘risk range’ of risk to play around in. So long as you don’t go over your set max percentage you have made for yourself, you are sticking to your rules. Making these decisions though really requires discipline. You can’t just cut your stop loss in half just to decrease your risk if you don’t think, based on experience, that you can hold the stop loss. The same thing goes with putting on more contracts, if it doesn’t fall into your parameters of being of the highest quality trades and you just want to double your size because you want more profit, then you may end up taking bigger losses than necessary. This is why all the professional traders will tell you, stay disciplined, don’t be greedy, stick to your rules, have a plan, etc. because it is the truth if you want to be in this business for the long run.
Trade Management:
“The strong point in poker is never to lose your temper, either with those you are playing with [big money] or, more particularly, with the cards [market]. There is no sympathy in poker. Always keep cool. If you lose your head you will lose all your chips.”
The whole point of planning out your trade management is so you can trade like a robot without thinking, action = reaction. Unless you want your emotions to take over your entire trade after you have gotten into it, then you will want to plan out how you are going to manage your trades before you take them. Trying to figure out what you should be doing while you are in a live trade is the worst thing ever. To tell you the truth, most of the time you are in a trade you really don’t do anything. That doesn’t mean when you do need to take action that it’s not very important. This is an extremely personalized process and you need to decide what you are the most comfortable with and how you feel a trade is best managed. All I can do is give you things that you need to think about for yourself on this one. Your management plan should be roughly the same for every trade you take, this is so your probabilities will align correctly. That doesn’t mean during changing market conditions you make small tweaks to the plan to better fit how the market is currently trading is not acceptable though, but that will come with experience as you learn to adapt to changing markets. The bottom line is you need to know what you are going to do after you have entered that trade so you aren’t trading with your emotions. The four things you should know how you will handle are; your position size, what kind of stop loss you will be using/what your exit strategy is; if you are going to scale into anymore contracts; and how long you are expecting to hold this trade.
Position Size:
Knowing what your position size is going to be for what type of setup you are taking is something you need to know ahead of time. This goes back to the risk/reward section above, you have the ‘risk range’ that gives you some slack to play around in but you still need to know what kind of setups you are going to be more aggressive on and what kind are still trades you like but may want to ease off on the risk with ahead of time. For me, an example of the ones I am aggressive with are the setups with very crisp market structure and have historically yielded very large moves in a very short amount of time. Maybe while you are still learning how to feel out the energy of the market pressure, structure, and location you choose to just use a singular position size for all of your trades until you learn for yourself which ones are the absolute highest probability and yield the largest profits.
Stop Loss/Exit Strategy:
You need to know how you are going to handle your stop loss and exit strategy. Are you going to trail your stop? If so, how far behind price? Is it just going to be a static stop the entire trade (never moves)? Are you going to move it to breakeven, if so when would you do that? Will you have limit orders placed as targets or trail aggressively as you approach your predefined reward in your R/R ratio? Will you trail half of your position aggressively and other half conservatively? These are just examples of what you need to be asking yourself and plan out before you are in the trade. Maybe there is something better that I didn’t list here. If you think that is the better way to manage the trade, great, at least you are planning it out ahead of time. You don’t get any smarter after you get filled. It is very important that you backtest or use a simulator, don’t use your money for running tests.. use it for growing into wealth.
Scaling:
Like I mentioned earlier, scaling is a good part of my trading when I get the chance and typically leads me to my most profitable trades. I never recommend scaling into trades at a loss because I believe in cutting trades that don’t work, “losers average losers”. It typically leads to digging yourself into a hole that you wish you had never got into. Now for long term holdings in equities, scaling at a small loss is fine (for me) as long as the reason I got into the trade is still the same, my pre-defined stop is still a good distance away, and I am not maxing out my risk range. With that said, I still hardly ever do it. Scaling into more while you are winning is a different story. You can get to a point where you can double your initial entry and still have a breakeven trade (or a loss equivalent to your initial risk), you just have to accept that sometimes you will get stopped out at breakeven after being in the green on the trade or turn a profitable trade back into a loss of your initial risk. Some of you may choose not to scale at all which is fine but it needs to be in your plan, that way you when you are in the trade you know there will be no scaling involved. The same goes if you are willing to scale more, you need to have planned out; when you are willing to scale more or how far into the trade (this will determine your new risk), what kind of entries you are willing to take for a scale in, how much you will scale in (also will determine your risk), how much more potential reward you would need for a scale in to be acceptable, and how you will handle your average price (exit strategy). For example, for me I need to be well enough into the trade where I can double my initial entry and still keep the same amount of risk (or less) as my initial entry. I need it to be good market structure with energy, no less than 50 ticks (or 5 S&P points) potential reward left, and I always trail my stops with or without a scale.
Holding Period:
How long you are going to hold your trade isn’t so much something you can plan for, but rather be aware of. None of us can really know for sure how long something is going to take to work, but we can know how long it usually will take to work. For example, if you are looking for 75 ticks in the Russell and you are starting to get squirmy after 10 minutes, you aren’t really aware of how long you are going to have to hold that trade to achieve that target assuming the rest of your analysis is correct. I know some position traders, including myself, don’t care how long they are going to be holding a stock position. It could be a weeks, months, a year, etc. The thing is we are aware of how long it is necessary to hold the trade to achieve the kind of returns we are looking for in that particular trade. This is something you should be thinking about when you are calculating your R/R ratio, how long it is going to take (on average) to reach your potential reward. If you are wrong on the trade, your stop loss will take care of it. You don’t need to be sitting in losers, you need to be sitting in the winners if you want the big money. When I was first getting started, this was a problem of mine and primary because no one ever talked about it. I expected the returns to come much faster than I should have been and it effected my psychology while I was in the trade until I actually studied this part of trading, figured out how long a trade took on average to achieve a nice move, and then started watching the clock on a regular basis while I was in trades.
Conclusion:
The above chart is a trade that I took a while back and I mapped out the process for this blog post. Crude had been hitting the second open range target nearly everyday of that week, so I knew the probability of that target being hit was fairly high so that is what I based my targets on. There was also a scale that I did that gave back the profits I had already made, doubled the position, and made it a breakeven trade had I gotten stopped out. I drew the red dot (trailing stop) above the bar that I moved it on as the bars closed, and you can see how I got really aggressive with the stop as it moved closer to my target. I specifically tend to do that when the price spikes into the targets very quickly as it did that day. I mapped out the R/R using a tool from my platform as well. I mapped them as individual trades and as a blended trade so you can see what was going through my mind. I knew how long I likely needed to hold the trade which ended up being about an hour, my scale kept within my trade plan rules, I had good risk/reward along with keeping in my risk range, my position size was just normal as this isn’t in my highest quality setup parameters, I knew the long term statistics of hitting the open range targets, and my entry setup probabilities along with the probabilities of the stop holding. My trade plan is always front and center when I am trading.
I wanted to say something about a simulator. A lot of people don’t believe in simulators because they don’t know how to use them correctly. They are pretty useless if you don’t trade them like you normally would your own trade plan. When you trade your trade plan, it is building your mind up to give you the mentality of a trader so that when you start using live money, you won’t have no idea what you are doing. A simulator will help with your psychological state of mind, when using a simulator your emotions are pretty much not there since there is nothing at stake so you are purely developing skill (as long as you are trading within your live account trade plan). Once you have developed the skill, logic, and profitability without emotions, you will have a reference point when you go live, you feel the emotions coming, and you start questioning yourself. You can ask yourself, “what was I doing in this situation on the simulator?” Not only that, but your mind will automatically revert back to when you were trading on the sim and pick up the skills you learned from there and bring them into real life, so long as you use the sim correctly. Go right now and start working on a trade plan based on the guidelines I gave you here, and then use a simulator to put it to work in the live markets. You will start to see what fits into your personality and you will make changes accordingly until you are ready to go live after a few months of this.
The market doesn’t care about you, it doesn’t even know who you are. It will take all of your money, or it will give you a fruitful life to live depending on what you decide to put into it and if you use it correctly. The market is a tool that you use to extract money from, nothing else. If you didn’t know how to use a power saw, you would chop your hand off. The same goes with the market. It is like a computer program, if you input the correct code the computer will output the results you are looking for. The code you have to put into the market is a trade plan with discipline and a profitable strategy. The difference between a strategy and a plan is simple; a strategy tells you when to enter & exit trades, and how you analyze the markets (basically everything I have posted in the education section besides this blog), and a plan outlines the parameters you are going to follow to keep your account alive and keep you in the business for the long run (everything in this blog). In my opinion, the best strategies are the ones that can pull out huge moves in the market with little amounts of risk and that is what I have put my focus toward my entire trading career. I studied people that have stupid amounts of wealth and I can guarantee you they never scalp out of their positions, they never go for less than what the market offers, and they always keep their risk and trade plan in check. It sounds easy enough but you would be surprised how many people would rather pull out little amounts of money at a time a whole bunch of times because they can’t get their emotions out of the way long enough to hold onto a winning trade, and they would rather pay rent than build wealth. There are thousands of strategies out there, but really only one framework or basic features of a trade plan and the importance of that plan in this business is really beyond explanation. Most traders out there are searching for the holy grail strategy, when they should be searching for how to build a comprehensive trade plan. It is ok to look for a strategy that fits into your goals, that is different than searching for something new because you don’t have a set, personalized trade plan which is keeping you from profitability. I did my best to explain it to you here and if you just take the time to actually formulate your plan you will be ahead of 90% of traders already. I can go back and improve on some things if anyone has a comment they want me to clarify on.
Trade well,
-Michael
