If you have decided to give trading a yourself, here are a few good rules of thumb to follow. Your trade entry rules should address each of the following:
Let's look at these in more detail.
The cornerstone of technical analysis is the trend. Remember 'the trend is your friend' and you always want to trade with it, not against it. I believe this to be the most critical component of any trade entry system. You need a way to measure the trend.
There are many ways to identify trends, and as with most things in trading, there's more than one way to skin a cat. The key is to have a method in place.
One of my preferred methods for identifying trending securities is to find securities trading at their recent highs. That is to say, the highest high price must have been achieved in the past x number of days (where x is the variable depending on the timeframe you are trading). The longer the timeframe, typically the higher the variable.
If I were to trade a medium to longer term approach I might want the highest high price in the past 200 days to have occurred in the past 20 days.
I use a charting package called MetaStock (covered in more detail in chapter 8). Using MetaStock the formula would look like:
HHVBars(H,240) less than 20
Liquidity is an important determinant because you want to be trading securities that you can buy and sell quickly and without moving the market. You never want to be caught in a position where you want out but there's no one to buy.
With liquid stocks, such as the forex market that trades billions of dollars each day, trades are happening constantly, so your activity alone will not move the market. In short, avoid illiquid securities.
Depending on the size of your float, you might want the average daily trade volume to be greater than $400,000. This could be achieved by requiring that:
The 21-day average of volume multiplied by the closing price be greater than $400,000.
Using MetaStock the formula would look like:
Mov(v,21,s)*C greater than 400000
Volatility is simply a measurement of how much a security moves. Volatility is not a measure about whether it goes up or down, just how much it fluctuates.
It is important to trade securities that move enough for you to make a profit. Of course you don't want securities that are so volatile you can't get to sleep at night. On the other hand, you don't want something that moves at such a snail's pace that it is not delivering the returns you are after.
One of my favourite ways to identify volatility is using the ATR method which indicates how much a security will move, on average, over a certain period.
Here's how I might use this method. A $10 security might have moved fifty cents on average over the past 21 days. I can simply divide this value by the price of the security to calculate the average percentage movement of a security over the past 21 days. With this value, I can stipulate a minimum and maximum volatility value.
If I were a reasonably conservative trader I might want a security to trade between a band of 1.5-6%. That is to say, I want the ATR divided by the average closing price, over the past 21 days, to be greater than 1.5% and less than 6%.
Using MetaStock, the formula would look like:
ATR(21)/Mov(C,21,S)*100 greater than 1.5 and
ATR(21)/Mov(C,21,S)*100 less than 6
Tip: A great place to start when researching your trade entry rules is to print out all the trading candidates you would have liked to have traded in the past. Next, mark on the charts themselves where you would have ideally liked to have entered. Finally, look for common characteristics among those trade entry points - these similarities can form the basis of your trading entry rules.
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