Before You Make a Trade

Before You Make a Trade
By Jim Wyckoff

A "Trading Checklist" of prioritized criteria not only will help you decide when to execute a trade, but will also help you identify potential winning trades.

What kind of stuff should a trader put on a Trading Checklist? That depends on the individual trader. Each trader should have his or her own set of criteria, or rules, that helps determine a market to trade and the direction to trade it--including when to get in and out.

Below are my Top 10 rules on my trading checklist.

1. Are shorter-term and longer-term charts in agreement on price trend?

I've told readers for years that this is my No. 1 trading rule. If the weekly, monthly and daily (and sometimes intra-day) bar charts are not in agreement on price trend, I'll likely pass on a trade. I'm usually a trend trader, and the "trend must be my friend" before I make a trade.

2. Is this potential trade within my financial risk tolerance?

To be a successful trader, I not only have to have winning trades, but I must survive the more numerous losing trades I am likely to encounter. If I see a potentially profitable trading "set-up," but the market is too volatile, I'll likely pass on the trade because of the potential for a big drawdown or even a margin call from my broker. An example is the energy markets a couple years ago. They were highly volatile. Certainly, there were some big moves (and trading opportunities for some) in the energies--both up and down. However, when a 75-cent, or more, daily move in crude oil is a "routine" trading session, that market is too volatile for my risk tolerance--at least when trading straight futures.

3. What is the potential risk-reward ratio of the trade?

My risk-reward ratio in a futures trade should be at least three to one on maximum profit potential. In other words, if my risk of loss is $1,000, my maximum profit potential should be at least $3,000. Anything less is not worth making the trade. Now, any eventual profit that is made may not always attain that three-to-one risk-reward ratio, but the point here is there should be the "potential" for a profit three times greater than your capital at risk in the trade.

4. Has there been a price "breakout" from a trading range?

One of my favorite trading "set-ups" is when prices have been in a trading range--between key support and resistance levels--for an extended period of time (the longer, the better). This type of trading range is also called a congestion zone, or a basing area when at historically lower price levels. If the price breaks out of a range (above the key resistance or below the key support), I like to enter the market--long on an upside breakout or short on a downside breakout. A safer method would be to make sure there is follow-through strength or weakness the next trading session--in order to avoid a false breakout. The trade-off there is that I could be missing out on some of the price move by waiting an extra trading session.

5. Is there a potentially good entry point if the trade looks good?

Entry points in trades most times should be based on some type of support or resistance levels in a market. If I see a potential set-up for a long-side trade, I will wait for the market to push up through a resistance level and begin a fledgling uptrend. Then, if I do go long, I'll set my sell stop just below a support level that's not too far below the market. And if the trend does not develop and the market turns back south, I'm stopped out for a loss that's not too painful. Another way to enter a market that is trending (preferably just beginning to trend) is to wait for a minor pullback in an uptrend or an upside correction in a downtrend. Markets don't go straight up or straight down, and there are minor corrections in a trend that offer good entry points. The key is to try to determine if it is indeed just a correction and not the end of the trend.

6. Is there a support or resistance level nearby, at which I can set a protective stop when I enter the trade?

This is my exit strategy, and is one of the most important factors in trading futures. On when to get out of a market, I have a simple, yet very effective method: Upon entering a trade, if I place a sell stop below the market if I'm long (buy stop if I'm short), I know right away approximately how much money I could lose in any given trade. I will never trade straight futures without employing stops. Neither should you. Thus, I will never be in a trade and have a losing position and not know where my exit point is going to be.

7. Do "fundamental" market factors raise any warning flags?

Those who have read my features know I base the majority of my trading decisions on technical indicators and chart analysis--and also on market psychology. However, I do not ignore fundamentals that could impact the markets I'm trading. Neither should you. There are U.S. government economic reports that sometimes have a significant impact on markets. Associations also release reports that impact futures markets. Even private analysts' estimates can move markets. I make it a priority to know, in advance, the release of any scheduled reports or forecasts that have the potential to move the market for which I'm thinking about trading. I don't like surprises when I am in the middle of a trade.

8. What do computer-generated indicators show? (RSI, DMI, Stochastics, etc.)

Some traders use the Directional Movement Indicator (DMI) as a complete trading system. Also, some traders use the Relative Strength Index (RSI), Slow Stochastics or other computer-generated technical indicators solely for determining entry and exit points. I do neither and here’s why: I consider these computer-generated technical indicators to be secondary, yet still important, trading tools. I will use these "secondary tools" to help me confirm or reject ideas that are based on my "primary tools"--which are basic chart patterns, support and resistance levels, trend lines, and fundamental analysis.

9. Do volume and open interest provide any clues?

Most veteran futures traders agree that volume and open interest are also "secondary" technical indicators that help confirm other technical signals on the charts. In other words, traders won't base their trading decisions solely on volume or open interest figures, but will instead use them in conjunction with other technical signals, or to help confirm signals. As a general rule, volume should increase as a trend develops. In an uptrend, volume should be heavier on up-days and lighter on down-days within the trend. In a downtrend, volume should be heavier on down-days and lighter on up-days. Changes in open interest also can be used to help confirm other technical signals. Open interest can help the trader gauge how much new money is flowing into a market, or if money is flowing out of a market. This is helpful when looking at a trending market. Another general trading rule is that if volume and open interest are increasing, then the trend will probably continue in its present direction--either up or down. And if volume and open interest are declining, this can be interpreted as a warning signal that the current trend may be about to end.

10. What is the prevailing general opinion of the market? (Possible contrary thinking.)

When I was working on the trading floors of the major futures exchanges, traders would many times "fade" (or trade against) the featured articles on commodities in the major newspapers, such as the Wall Street Journal. They figured that if the general financial press had picked up on a market (such as a drought driving grain prices higher), then that uptrend must be about over. Contrary opinion in the trading business is defined as going (trading) against the popular or most widely held opinions in the marketplace. This notion of "going against the grain" of popular market opinion is difficult to undertake, especially when there is a steady drumbeat of fundamental information that seems to corroborate the popular opinion. If you've read books on trading markets, most will tell you to have a trading plan and stick with it throughout the trade. A main reason for this trading tenet is to keep you from being swayed or influenced by the opinions of others while you are in the middle of a trade. Popular opinion is many times not the right opinion when it comes to market direction.