I often hear students complaining about having been stopped out too early or taking bad trades they wished they had passed on. One thing traders must remember is that they do not have to jump into every trade they see. The key to being successful in the markets is consistency. New traders must learn that taking small losses which are erased by small and large wins is going to be much better than taking many losses that you hope are erased by only large wins. You must pick your battles (trades) in the market. Remember, the market will open again tomorrow and offer you more opportunities.
So how can one filter out some of the less desirable trades? Well, you should start by analyzing your trade BEFORE you enter it. Trying to analyze a trade once you are in it is useless since you have a vested interest in the outcome. You are now biased, and you will slant your research toward your position working out even if it is not the correct direction. Before you enter your trade, you should know:
- Your entry point and reasons for entering the trade
- Your target for entering the trade for a profit
- How much you will risk on the trade (where you will place your stop)
By knowing these three items before you enter the position, you can filter out trades that are too risky. I’ll explain how to do that in a bit, but first I need to explain a technical analysis tool called the Average True Range. The range of a stock is simply the difference between the high and the low for the period. However, the True Range accounts for any gaps in price that may have occurred. The True Range is the greatest of:
- The current high minus the current low
- The absolute value of the current high minus the previous close
- The absolute value of the current low minus the previous close
The Average True Range (or ATR), is simply the moving average of the True Range over several periods, (usually 10 or 14). Since you can set your charts for different timeframes, you can observe the Average True Range for any period. The ATR will let you know how much vibration there is in price for the time period you are trading. If you are looking at a five minute chart, the 10 period ATR will show the average price vibration per five minute period, over the last 50 minutes. On a daily chart, the 10 period ATR denotes the daily price vibration over the past two trading weeks (assuming five trading days a week).
Let’s get back to filtering our trades. If you do your proper planning on your trade, you should have the three key elements identified: Entry, Target, and Stop. Remember that your stop should not be greater than 1/3 your potential profit on the trade. This allows you to be wrong more than you are right and still be profitable in trading. We must now filter our trade via the ATR for the timeframe we are trading. If we are planning an intraday trade on a five minute chart, we need to check our stop against the five minute ATR. If we are looking at a swing trade for the next several days or weeks, we look to the ATR on a daily chart. I have a simple rule that keeps me from taking risky trades:
If the Max Risk (1/3 potential profit) is less than the ATR then pass on the trade!
If I were to place my stop inside the ATR for the timeframe I am trading, then I have a high probability of getting stopped out due to the normal vibration of the stock rather than being wrong in predicting the direction of the price. Now I should mention that there is a guide for placing your stops properly with the ATR as well. If your maximum risk allowed is greater than the ATR for the timeframe you are trading, you do not have to place your stop at the maximum risk point. You can multiply the ATR by 1.5 and use that for your stop. This will help prevent getting stopped out prematurely and will also limit your risk in the trade. If you find that multiplying the ATR by 1.5 gives you a number greater than your maximum risk allowed (1/3 your potential profit), then use the smaller of the two.
Stops are placed to prove you were wrong in your prediction of price movement. Getting stopped out by vibration is frustrating and can be avoided by using this simple filter. Will you miss out on some profitable trades? Yes you will, but you will also miss out on many unprofitable trades that would damage your account further.