Have Great Strategies, and Even Greater Risk Management

These five steps will help you achieve consistent profits in any market. It doesn’t matter if the market is trending up, down, or sideways. All you need to do is keep these steps in mind.

1. Know Your Market
2. Analyze Your Outcomes
3. Plan Your Trade
4. Trade your Plan
5. Protect Your Profits

Step One: Know Your Market

The first step is to find a market you are interested in trading. Study it for a few days, weeks, or months. I have personally been known to watch a security for 2 or 3 years before making a trade. Sometimes it takes me a while to learn the fundamentals of the underlying instrument. Other times, the setup isn’t quite ready yet. Although 2 years is an extreme, sometimes I only need a few days to get comfortable with a given market. Your comfort level is truly dependent upon your skills as a trader. Patience is always a virtue.

Having intimate knowledge of the markets you trade is an advantage, not a detriment.

Furthermore, being comfortable with the liquidity, volatility, and behavior of a security is also essential to successful trading. The last thing you want to do is find yourself trading a highly illiquid option contract just because you think the underlying security is going to break out to the upside. You have to be completely comfortable with the market, otherwise you put yourself, and your money, at risk.

Step Two: Analyze Your Outcomes

The best way to make money when the market goes wherever it wants to go is to devise a strategy. If you want to make the most of your capital, formulate a hypothesis and trade it accordingly. Establish scenarios for both sides of your thesis and adjust your risk accordingly. If you chase momentum you are destined to lose. If you trade an idea, you will stand a better chance of making money.

This is where technical analysis is really important. Your technical studies will teach you about the risks on both the upside and the downside. A proper analyst will know exactly how much he/she stands to lose before executing a trade.

Make sure to analyze your probabilities of success and failure. Think about your chances of making money, and conversely, think about how much money you will lose if you are wrong. Use my trade risk calculator to help you better visualize your risk/reward scenarios.

Step Three: Plan Your Trade

Come up with a trading strategy for the security you want to trade. Write it down, and make sure you stick to it. Generally speaking, it is much harder to get caught in a losing trade when you have written your trading plan on paper. Also make sure to keep this trading plan in plain sight so you don’t forget about it. I tend to use my blog as an outlet for my trading plans, although this may not be suitable for you.

Trading Nirvana

The best traders are the ones who know how to separate emotion from trading. Losing money is a horrible feeling and planning your trade can help to keeps your emotions in check. It takes time to train yourself to remove your emotions from your trades and this skill can only come from experience. I like to call it “Trading Nirvana”. Achieving trading nirvana requires you to dislocate the money from the trade. Not every trade works. When you do take a loss, make it a small one. If you can, always try to book a gain, no matter how small. Even $1.00 is still better than nothing.

Respect Your Leverage

Avoid leverage when possible. When you are use leverage, you are no different than a big bank or a well-capitalized hedge fund. The only thing that separates you from the big boys is the amount of leverage you use, how you use it, and how you manage it (not to mention about seven or eight zeroes to the left of the decimal on your account balance).

Excessive leverage will wipe you out in the blink of an eye. The drawdown will happen so fast it will make you do a double-take You will get mad, you will not know what hit you, and you will probably throw things in a fit of trade-induced rage. In order to avoid this, make sure to respect your leverage and set some stop loss orders shortly after placing your trade. At 4:1 leverage, a 2.5% loss can equal 10% of your trading account. Don’t pull a Lehman. Don’t pull a Bear. Be smart. Be Prudent.

If you have a broker that allows you to bracket your orders, make sure you take advantage of this capability.

Bracket orders are designed to help limit your loss and lock in a profit by “bracketing” an order with two opposite-side orders. A BUY order is bracketed by a high-side sell limit order and a low-side sell stop order. A SELL order is bracketed by a high-side buy stop order and a low side buy limit order. (Interactive Brokers)

In some illiquid markets it is not wise to show your intentions since you might get taken advantage of. This is why knowing your market is so important. In this case, you can set trade triggers based on price movement so that your orders do not hit the book until the right catalyst triggers an order.

Step Four: Trade Your Plan

This step is not always as easy as it sounds. Place your orders and wait for the market to fill your requests. Make sure to always place limit orders. Market orders are for suckers. If the market runs away from you, do not chase after it. Chasing momentum is the equivalent of pissing down the drain of financial ruin.

Step Five: Protect Your Profits

In summary, if you follow these five simple steps during your trading adventures, you will be able to increase your chances for making consistent profits in any market.

1. Have a system!
2. Trade markets not money!
3. Have a favorable risk to reward ratio!
4. Always trade with a stop loss!
5. Don’t add to a loser!
6. Strive for consistency!
7. Don’t be afraid to take a profit!
8. Avoid reversing your position!
9. If you have three losing trades in a row, take a break and examine your system to see if you’re doing anything wrong.
10. Remember, markets change and systems have to change with them.