Components of a successful trade

A trader needs to determine 4 important attributes for a successful trade:

• Direction
• Probability
• Room for profit
• Stop

Direction is obvious. If you are on the wrong side of the market, your chances of a scalp trade are smaller and chances of a swing trade are nil. A simple way to determine direction is to draw a trendline and trade only when the price tests the trendline. Trendlines should be drawn from the start of the move. Most days, this would be from the LOD or HOD but some days such as today, the beginning of the move could be a different bar such as b24. Experienced traders can also detect a reversal such as the three push reversal at b9 and trade the reversal of a trend. New traders should skip reversals and take the first reasonable pullback after the successful reversal (b24).

Probability of success takes slightly more experience to judge. On most days, after determining the market is in a trend, you can take every two legged pullback such as b44 until the trend breaks (a sustained move beyond the trendline). On hard trend days, you can take any pullback and any small signal bar in the direction of the trend as long as the entry side of the signal bar does not have a large tail.

Room for profit takes quite a bit of experience to judge. In a normal trend, a pullback can be expected to at least take out the prior extreme by one tick and therefore a deep pullback is likely to give sufficient profit. However in hard trends and large gap opens, even a couple of ticks may give a decent profit. High volatility and clean patterns are friends when it comes to profit targets. Barbwire and tiny bars are terrible enemies and greatly interfere with profit target estimation.

Stop size is possibly the hardest to correctly determine. Signal bar stops often work but could be too large from a risk:reward perspective. A fixed stop is easy to use for clear patterns and strong bars but very hard for channels and overlapped bars. For example, despite correctly reading the low of the day today, my stop was short by 1t resulting in a losing trade and missing out on a great swing setup.

Taking a fixed stop and continuously keeping track of market direction using the nine transitions means you only look for probability and profit target when entering a trade. Passing up shallow pullbacks means you only need to focus on probability, which boils down to looking for a clear set of patterns and strong signal bars.

The fewer parameters involved in your decision making, the more confident you will be in your decisions and help you become a successful trader.

The road ahead

My frequency of posting has reduced in the past few months but rest assured, with the generous help from my small research team, I'm actively working on bringing several important facets of trading to light.

A small selection of currently active research areas are listed below:

Trading Channels:
One of the most important problems in price action trading is to trade channels using a small fixed stop without resorting to scaling-in or other poor habits. Since channels are common, this is a top research priority.

Predict tight days that aren't worth trading: Some days are extremely tight and on a day with a four point range with choppy overlapped price action, trading is dangerous. Predicting such a day early enables us to stay out and skip trading.

Predict choppy opens that are likely to result in stopped out trades:

Opens that otherwise look like potential setups may never generate a profit and may stop you out or enter a chop zone. Correctly detecting this enables you to skip trading until price action becomes more amenable to trading. This chart is the AM of the FOMC day that eventually led to a huge rally.

Predicting Breakouts:
One of the hardest problems in price action is predicting which bar would lead to a successful break-out. For example in this chart, b57 short led to a breakout while every other signal prior to it failed. A high probability prediction of a breakout enables us to judiciously enter a profitable swing trade.



And more: I'm also working on exiting losing trades for breakeven or a few ticks loss by detecting trade failure early. The setups 1Rev and 1PB have been further broken down into a small set of distinct setups that enable the trader to anticipate and trade them bar-by-bar. As soon as these setups complete the requirements of rigorous testing, they will be published here in a series of blog posts.

The hard road to consistency X - The elusiveness of discipline

One of the great surprises in trading is that knowing what to do and the ability to do it are two unrelated things. Knowing what to do is knowledge, the ability to do it is skill. Its fairly easy to describe price action post-facto. Its simple to know to hold through a pullback or to exit on the next push if you aren't under pressure from holding a position.

Traders need to work on improving their trading to be close to the ideal post-facto decision as much as possible. For the most part, this is a constant struggle. Information is always imperfect and decisions are often hard to make correctly. The process of working on yourself to make the best possible decision given the information you have is what traders do constantly and may be simply called building discipline.

Discipline is more than just following your rules. Its also the ability to make correct decisions in the face of recent failures. Even the most seasoned traders would be impacted by successive failures or missed opportunities.

For example, a trader who was stopped out on a 1CBO buy above b14 may be hesitant to buy b19. A trader who missed the reversal at b13 may enter a larger size on b27, which he may see as a deep 2L PB. Every loss and missed opportunity are likely to cause some distress in the mind of even the most experienced traders eventually forcing more and more mistakes. Similarly, a well executed trade may give a heightened sense of confidence and invincibility, forcing rash behavior.

The resistance to such pressure is something that needs to be worked on and can only be developed with practice. The ability to see a trade setup independently of recent price action and your bout with the market is something you need to focus on constantly.

The guide to doing this is to evaluate the market movements as information and disregard trading as something you need to do. "I need to make 2 points today" or "I better take one more trade so I can end the day without a loss" are terrible advices.

Focus on the information you get from the market. Constantly work on keeping your evaluation as objective as possible. Ignore statements about the economy, foreign crises or anything else that other traders and the news are discussing. They have absolutely no weight compared to what the market tells you.

Building discipline is like quitting smoking. Easy for those who don't have to do it but extremely hard for those who do need to do so. Constant slips of discipline and breaking your own rules are to be expected. Look at the few examples of success around you for inspiration and keep working at it. Know that even fractional improvements in discipline add up and build you up as a trader.

The hard road to consistency IX -- The need to re-learn lessons over and over

A trader should be expected to constantly having to learn and re-learn lessons and this is just part of learning to trade. Some of this is due to being emotionally reactive. A trader who sees a huge bar like b8 may be tempted to sell below it and is likely to be stopped out. Similarly, a trader may short a bull trend all the way to the top and blow up an account.

The first step is to understand what made you fail. Did you enter on fear of being left out instead of waiting for a setup? Are you deficient in some price action principles? (shorting all the way to the top = does not understand trends can go on indefinitely). Are your stops too tight? Are your targets too lofty? Do you enter too early? Do you love to pick tops and bottoms? Do you enter before a signal bar closes only to find that the good looking bull bar 30 seconds before bar close is now a bear bar? Do you enter on limit banking on your ability to predict reversals to the tick? Do you misread overlaps and chop as patterns?

Whatever your errors may be, you need to first identify them. The next step is to figure out the right way to trade those situations. Ignoring actual reversals and taking the 1st pullback after the successful reversal alone eliminates over half the errors above. Using proper trade management eliminates most of the others. If you can get here, you should be breakeven to slightly profitable on most days. But to get here, you need to practice over and over and only sustained effort can break your bad habits.

Days where price action exposes a large gap in your experience (counter-trend trading on trend days) are likely to still create large losing days and therefore, you should switch to SIM to collect data on these days. Identifying market structure responsible for huge losses and acting on them is a much harder task, but the fact that you switched to SIM after two losing trades enables you to stay in the game and figure out ways to identify and trade such exceptional days.

Even so, there would be rare days such as the flash-crash that could still give you some trouble. But you would be far more confident in your trading and welcome the opportunity to learn from exceptional events.