Tuesday, February 24, 2015

Best Practices in Trading: Developing a Framework for Good Trading

Too many traders justify poor trading and overtrading by appealing to "intuition".  There's no question that intuition and implicit learning are cornerstones of pattern recognition.  That doesn't mean, however, that any trade one feels like putting on is a good trade!  Intuition is the result of extensive exposure to a field.  Without prolonged immersion and study, there is no building of pattern recognition skills.

An effective way of ensuring that your trading truly represents sound trading is to construct a framework for your good trades that captures their essential elements.  Today's best practice comes from reader Awais Bokhari, the co-founder and CEO of the OpenTrader training program and the eminiplayer trading site.  Awais has been involved in training over 1000 traders, so he has worthwhile insights into the building of trading skills.  He describes the trading framework he employs to aid execution and screen for valid trade ideas:

"After working with numerous traders, one common challenge I've noticed is that even after they have developed a solid understanding of the market and its mechanics, they still struggle with trade execution, and can't objectively determine the quality of a trade setup in real time.  So, even after they've developed a good trade plan, they're unable to execute that plan in real time.

To improve execution, I provide our students with an Execution Framework and teach them The Anatomy of a Valid Trade Idea.  The concept here is to break down the trading methodology/strategy and determine the common components that are at the base of every good setup.  We then track those components in a trade journal/spreadsheet with simple Yes/No values.  It's important that we're able to measure and track each component objectively.  This means we can't include or track anything that relies on intuition.

For our discretionary trading methodology, we follow four key components that make up a valid trade idea:

1.  Good Trade Location:  For a majority of trade setups, trade location is going to be important.  In many situations, trade location alone can be enough of a reason to enter a trade.  To make this an objective determination, you simply answer whether you took the trade at a predetermined support/resistance zone.

2.  Intraday Control/Bias (short term directional bias):  We can assess which side is in control on the day time frame by seeing where the market is trading in relation to the first hour high/low, midpoint, VWAP, VPOC (volume point of control), overnight high/low, and previous day's high/low.  Trades in the direction of the intraday control have a higher probability of reaching their profit targets.  When entering a trade that is counter to the intraday control, you should be more conservative with your trade location.

3.  Momentum:  We gauge momentum by monitoring the NYSE TICK in conjunction with price action.  Trades in the direction of momentum have a higher probability of reaching their profit targets.  When entering a trade that is counter to momentum, you should generally be more conservative with your trade location.

4.  Larger Time Frame Control/Bias (trend):  For the purpose of day trading, we assess the larger time frame control based on the 30-minute and daily charts.  Trades in the direction of the larger time frame have a higher probability of reaching their profit targets.  And, again, trades that are counter to the larger time frame/trend should usually be taken at more conservative trade location.

Confluence:  These four key components make up a valid trade idea.  The more of these you stack in your favor, the higher the odds of the setup working out.  As a rule, at least two of these components should be in your favor on every trade.

Reward-to-Risk:  R/R is used as a filter and is a prerequisite to entering any trade.  Because R/R is subjective and every single trade must meet our minimum R/R criterion of 2:1, R/R can never be used as the only reason to enter a trade.  It is necessary, but not sufficient on its own.

We've found that this execution framework allows our traders to be more objective and quickly determine the quality of a trade setup in real time.  Another benefit is that it allows the trader to objective assess trades at the the end of the day."

Awais has created a guide to trade selection that can assist traders in real time decision making and also facilitate review of winning and losing trades.  By applying these criteria to all trades all the time, the trader internalizes the basics of good decision making and turns excellence in execution into a positive habit pattern.

Further Reading:  How Many Daytraders Actually Make Money Consistently?