Up until now, we have been discussing about the technicalities of trading. In the next couple of chapters, we will go deep into finding out what makes a trader successful! Before we begin, it is crucial to know that all trading plans are best tested through paper trading before execution on the real markets.
We have mentioned that emotion is a trader’s worst enemy. To eliminate, or at least reduce the effects of emotion, we need to craft plans and rules to constantly remind us of our goals while we are trading. A plan is essentially a written set of rules that defines how and when you will place your trades, how to react to the trade if it does not go according to plan and when you should exit a trade.
Traders should always have a plan when entering a trade. Having a plan allows you to know exactly what you will do at each point of a trade. Price action can happen quickly, sometimes within a few seconds. You will need to know when you should cut your losses and stop the trade or when you should be patient and let the trade work out. If you have a plan, stick to it. It’s often already too late to think about a plan when you are already in a trade. If you entered a trade and realized you don’t have a plan, get out!
You can always enter the trade again when the opportunity arises. The market is always moving and a new opportunity will always present itself, you don’t have to brood over a lost opportunity.
Whenever you enter a trade, it is always good to prepare for some possible moves that may happen to a stock. For example, if you are interested in a very beat down stock that has been going down for a few days, it is possible that there might be a small pull back into the green before going further down or up. This is something you can attempt to anticipate and write into your plan.
Here are some sample rules to follow when crafting a plan:
1) Cut losses quick.
2) Only trade familiar setups. When in doubt, cut the trade or don’t enter it at all.
3) Never trade irrationally for the fear of missing out on a trade, there is always another chance.
You need to do what works for you but never deviate from the rules you have set for yourself. They should be the cornerstones of your trading philosophy.
Enter/Exit a Position
Planning for the entry and the exit of a stock is usually the hardest for a new trader. An entry should not be based on emotions. In other words, you should not buy a stock when it obvious to everybody that it is a buy. If a chart is trending upwards and it is signaling a strong buy, a seasoned trader will only buy and enter a trade when the chart has pulled back. This is also called buying on the dip or dip-buying.
It is normal for a stock to pull back after a strong upwards push before continuing to push to greater highs. If you buy into the stock when it has not pulled back, and it pulls back right after you initiate your position, you will find yourself in a very unfavorable position from the very start. Even though eventually the stock may continue going higher, this pull back may spook you and cause you to sell in panic to protect your losses. This is a very critical mistake made by new traders.
The most common kind of exit is after a stock has hit a certain profit target the trader has set in mind before initiating the trade. Another scenario in which a trader will exit a trade is when a trade has hit the stop loss or trailing stop loss. This strategy has proven to work well over the years and allow many traders to protect their profits.
Scaling In/Scaling Out
Scaling into a trade refers to the act of adding more shares to a position that you have already initiated. One of the tricks to making the most out of a winning trade is by knowing when to scale into a trade. This might be difficult if you are trading on a very small account because of your limited capital and experience. However, once you have built up a reasonable amount, or greater than $10,000, learning how to scale in and out of a trade can really push your trading to the next level.
The reason why a trader would scale into a trade is to enhance their gains on a stock that has already begun to show promise. Larger trade sizes will result in larger profits if the trade moves in the direction a trader anticipates. Hence, if the trade is moving in the right direction, it only makes sense to add into a winning position so that profits can be maximized.
Scaling out of a trade is a similar idea to scaling in, but in reverse. Instead of selling a hundred percent of the existing shares when the profit target has been hit, you sell a partial portion of it instead to reduce the position size. The rationale for scaling out is that traders will never know how far a stock can go in their favor and therefore, only a partial position should be closed at first to capture some profits. The rest of the position size should be left to possibly run further into profitable territory.
Planning when to scale in and out of a trade is very useful in ensuring that you capture the most profits out of a stock based on your risk. The downside to this is that it can cost a lot of commission money to enter and exit a trade repeatedly. If you are able to master this, the rewards are well worth the costs involved.