Being sure to thoroughly answer these seven questions before putting on a trade will ensure that proper planning and risk management parameters are in place, writes Price Headley of BigTrends.com.
Often when we seek answers to combat the chaos of trading, it helps if we ask the right questions and have answers for them before we enter any trade.
Read on below for my top pre-trade questions:
1) What Is My Plan for Getting a Good Entry Point?
The key to good entries is putting on trades where there is relatively low risk compared to much higher reward. You also should have a clear catalyst for the expected stock move.
2) Where Will I Exit for a Profit—or a Loss?
You should define an initial stop point for your trade at the point where the trend is invalidated. It should also be in line with the maximum amount you are willing to risk and not a penny more.
It's also useful to have a “trailing stop” technique to protect your profits. On the profit side, where will you exit, and will you scale out or take the whole position off at once?
3) What Type of Order Will I Use to Enter and Exit?
When entering, I like to use limit orders, good for that day only, while exits are often market orders. Why? Because limit orders allow me to define my risk and reward clearly upon the entry of a trade, and while I need to get out, market orders allow immediate exit compared to the risk of missing my exit with a limit order.
4) What Percentage of Capital Will Be Devoted to the Trade?
The amount of capital I typically use is 10% per trade in my own accounts. I know traders who commit anywhere from 5% of their account per trade to 20% of their account per trade. Your goal should be to keep portfolio risk at less than 2% per trade. (For example, if you invest 20% of your portfolio in a trade, a 10% loss on that position would lead to a 2% loss on your portfolio.)
5) How Many Positions Will I Focus on at Once?
I like to concentrate my portfolio in my best ideas; plus, I like to stay focused on how each stock is acting. If my portfolio is too big (I'd say more than 15-20 stocks can be too many to focus on, but it varies), then I will lose focus and invariably miss an exit on a trade that I should have previously exited.
6) How Long Will I Leave This Trade on?
You should always have the time frame for the trade in mind. If it is a daytrade, never turn it into a swing trade and leave the position on overnight simply because it is at a loss (but hasn’t hit your stop yet) or hasn’t hit your profit target. Make the decision before you enter.
7) How Will I Review This Trade After It Is Over?
Have an end-of-day routine to close your day. Review your trades, and assess whether or not you followed your plan. Keep a log of all your trades and make comments on each position.
To learn more about Price Headley, visit BigTrends.com.