Three Things You Must Know Before Entering a Trade

09/01/2010 12:01 am EST

Focus: STRATEGIES

Successful trading is not a game of chance or luck, it is a strategic approach based on a technical understanding of price movement in the market. Naturally, there are many important things that a trader must know and identify before they would ever consider taking a trade. However, there are three things that I will discuss in this article that are paramount to the success and profitability of any trade.

1) Support and Resistance

Many traders overlook the importance of support and resistance on a chart. Support and resistance are two important concepts that must be carefully analyzed by every trader.

Support and resistance levels help us to see where buyers and sellers are on the chart. Support occurs at points where there are an abundance of buyers, ready and willing to buy at the support level price. The exact opposite occurs at a point of resistance, when the market has an abundance of sellers at the resistance level. The sellers outnumber the buyers and price tends to drop when resistance levels are met.

Before entering any trade, a strategic trader must know where their trade is relative to support and resistance levels. Support and resistance are typically defined by price zones, rather than absolute, set values or prices.

If you are taking a long trade, you want to be above support and well below a resistance zone. There is no sense in entering a long trade that will quickly confront a price resistance level.

Similarly, in taking a short entry, you would like to be below a resistance level that was not broken and well above the price support zone.

2) Direction and Presence of Momentum

The first thing that a trader must determine before taking a trade is the presence and direction of momentum in the market. Identifying the presence and direction of momentum in the market will allow a trader to benefit from the natural force of price movement. Many traders lose money on their trades because they enter their trades in the opposite direction of the momentum in the market.

Momentum is an incredibly powerful force in the market and it is far more advantageous to trade with it rather than against it. It is important to note that momentum is not always present in the market. The markets can experience prolonged periods of non-directional, or sideways, movement. So don’t count on always finding momentum in the market. In addition, when you do find it, it’s not always going to be equal in intensity.

In directional, or trending markets, when they do occur, momentum is always in the direction of the trend. In directional markets, a prudent trader is always taking trades in the direction of the trend. There are a number of ways to identify the direction of trends, one of the simplest being to look at the slope and direction of the ten-, 20-, and 50-period moving averages for the period that you trade. If all of them are parallel and increasing in value in the same direction, that is the direction of the trend.

3) Risk and Reward

Before placing any trade, a strategic trader must always know and identify the maximum risk exposure for the trade. Once the risk is identified, it should be compared to the possible profit target. If the profit target does not justify the risk exposure, the trade should not be taken. It does not make any sense to risk a dollar to earn a penny. One of the common mistakes that cause traders to consistently lose money is that they fail to let their winners run. They quickly close out their trades as soon as they become profitable. While no one can argue against taking a profit, consistently taking profits that are not consistent with the desired risk/reward ratio ultimately leads to a net loss. Once a stop is hit, it immediately eradicates the small profits of three or four trades that were prematurely closed. It is hard to leave your money on the table, but there are ways to move up your stops and use a trailing stop to allow you to stay in your trades to realize your designated target.

Once a trade is placed, prices will always fluctuate; that’s the nature of the auction process. Rarely will a trade directly navigate to the profit target without a retrace. This is where paper trading comes into play. It allows a trader to watch, learn, and record how long it takes to reach a profit target and whether the risk/reward strategy that they are using is in fact feasible and workable.

Since not all trades are likely to succeed, your reward should always exceed the amount of the risk in the trade by at least a factor of two.

By Dr. John Keppler

To learn more from Dr. Keppler, be sure to visit his Web site: Strategic Trading

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