Trading is an activity often portrayed as the way to riches by today’s online gurus who seek to exploit the public’s relatively limited knowledge about this practice.
However, like any other business activity, trading financial assets involves adopting a systematic process that starts with learning the basic rules of the tradecraft to then follow a disciplined approach to execute transactions in a cold and heartless way.
Most of those who participate in a day trading community and who have been successful at this endeavor agree that this systematic approach increases the odds of success and, in this article, we outline some of the steps that traders typically take when assessing potential transactions.
#1 – Analyzing the macro environment
Most early mornings for traders start by taking a look at what is going on at the macro level in the markets. This includes analyzing the situation in major global stock indexes or for the most relevant assets within a certain group.
The macro environment may also involve changes to macroeconomic factors in key latitudes like the United States such as employment, interest rates, inflation, and other similar matters.
The idea behind this practice is to follow the time-tested adage of “trading with the trend”, which emphasizes the importance of not placing trades that go against the direction of the overall market.
#2 – Performing technical analysis on the instrument
Technical analysis is a discipline that involves assessing the price action in a certain financial asset to determine the direction that the price may take in the future. Technical analysis also tends to evaluate how trading volumes have behaved and the most advanced techniques incorporate information from the market’s structure such as bid/ask spreads and buy and sell order volumes.
This analysis is crucial to establish a thesis on what the price of the asset may do in the future. It is important to note that TA does not aim to predict what will happen. Instead, it analyzes the most likely scenario based on past data.
#3 – Checking the presence of potential catalysts
Catalysts are events that have the power to start, reverse, or maintain a price trend. These catalysts can come in the form of news, changes in the macro environment, material changes in the situation of the underlying asset, and other similar developments.
The name comes from the fact that they can be considered a “starting point” to further validate or invalidate a particular thesis depending on the nature and expected impact of the event.
#4 – Defining entry and exit targets
Once a trader has identified an opportunity, the system will demand an entry and exit target. The entry target is usually a price at which a buy or sell signal is triggered and that provides a high-enough reward-to-risk ratio.
Meanwhile, the exit target is the price at which the trader will feel that the transaction has met his most optimistic scenario for the instrument. Some traders use trailing stop-loss orders to avoid taking profits too early if the price keeps rallying above the exit price.
In most systems, trades are accepted and positions are opened only if they comply with the minimum reward required for the level of risk assumed – that is, the maximum loss that the trader is willing to take.
#5 – Adopting appropriate risk management strategies
Risk management strategies are even more important than the potential profits that the trader can realize through the operations he is engaged in. The reason for this is that inappropriate risk management may lead to rapid and severe losses.
Some of the most relevant risk management techniques include:
– Setting stop-loss orders for all open positions.
– Limit the size of each position to 5% or less of the total portfolio.
– Avoid opening highly-correlated trades. For example, buying oil stocks along with oil futures.
#6 – Analyzing results
The process of dissecting past trades is crucial for traders to understand what has gone wrong or what has worked to keep fine-tuning the system to increase its win rate and profits down the line.
This process starts from top to bottom. If one follows the steps outlined before, a thorough assessment can be conducted every day to check what happened. This test involves asking questions such as:
– Was the macro analysis correct?
– Was the technical assessment accurate?
– Was the position closed earlier than expected?
– Were risk management policies followed to the letter?
Being a profitable trader is not impossible, yet it does demand a fair degree of discipline, technical expertise, and systematic thinking. The steps outlined above should paint a clearer picture to beginners of how trading looks like in practice to get rid of the myths and lies that online gurus typically want to push to sell courses.