Chapter 16. Reviewing the Entire Plan
Let’s take a look at the trading strategy we have laid out so far.
Chart Work
The strategy begins with the arduous process of navigating through a multitude of charts. I encourage you to make this a daily routine. If your schedule does not allow you to sift through charts on a daily basis, find a consistent time that works for you. This is the foundation to build on. If you skip this step, you might as well make a check payable to Mr. Market and call it a day. I have a rule that I live by: No chart work, no trading. It is through this process that you gain a feel for the underlying stock action within the market. You should not rely on the opinion of others. More often than not, they are guessing anyway. In fact, the more chart work you do on your own, the more you will view outside opinions as nothing more than noise. It is why the greats worked in silence, and it is why my staff, who sit in offices just around the corner from me, communicate with me through instant messaging. I realize it’s a bit manic, but it works. Your routine may consist of going through all charts within the NASDAQ 100, the S&P 500, or a variation of the two. Through this continuous process, you will become familiar with the underlying charts and their daily movement. Over time, you will begin to feel the rhythm of the market. Through this tedious but rewarding process, you will seek out patterns that will become your trading opportunities. It is imperative to let these patterns come to you. More than likely, you will initially see certain patterns that may or may not exist. In due time, this will subside. As you see how stocks develop firsthand, you will observe how the patterns resolve themselves. I encourage you to review the same stocks (and not new ones each time) again and again so that you become familiar with them, to the point of knowing which stock you are looking at based on its pattern rather than seeing the symbol.
Pattern Recognition
Through your consistent chart work, you seek to find patterns from which you may derive a trading strategy. The foundation of pattern recognition is rooted within technical analysis with an emphasis on lateral and angular trend lines. At this point, you have already quantified your style as anticipatory, reactionary, or delayed reactionary and have established your primary methodology of going with the trend or seeking to profit from a trend change. Over time, you will narrow your chart work to individual opportunities. As you grow as a trader, you will not only seek to play basic patterns but the failure of these patterns as well.
Developing Your Trading Plan (Journal)
Before executing any trade, you must make a note of your read in your trade journal. Write down what you see and why you want to take the trade. Base this on your technical analysis edge and not any qualitative opinion. Within this written plan, quantify your desired trade management before ever executing your trade. By keeping a solid record of your thoughts and your trade-management plan, you will have a detailed account you can look back on and learn.
Stop Level
Within your trading plan, articulated within your trade journal, you will first identify the level at which your identified setup would no longer be valid. This will become your stop. Using this stop level, you will then calculate your share count, based on your predetermined risk amount. If you are taking a trade in anticipation of a move transpiring, your stop should correlate with the level where the pattern itself is no longer valid. If you are trading reactionary, once a move has already occurred, your stop would be at the point that the pattern reversed (thus making your reactionary entry wrong).
Share Count
Before placing any trades, use your predetermined risk amount divided by the difference between entry price and your stop price to calculate your share count. After you determine the share count, you can execute the trade. When the trade has been executed, your stop order is entered.
Profit Levels / Limit Orders
When you have executed your trade, immediately calculate your profit levels based on your original risk per share. You should place limit orders to sell or cover a part of your position to ensure execution once the trade has reached your first predetermined profit level. Some brokers do not allow “bracket orders,” where both a stop order and limit order is set at the same time. Contact the service department of your brokerage firm to understand their process if you are unfamiliar with this. Your broker should be more than happy to help accommodate your trading plan. If they are not amenable to your strategy, consider finding a new broker.
Ongoing Execution
After a trade has been placed and orders entered, you continue to execute your original trading plan. Note your results over a large enough sample set to help you determine areas that might need to be improved.
Let’s review an example.
Example: Mosaic Company (MOS)
As I pursued my daily chart work throughout March 2010, I noticed an angular, ascending trend line in Mosaic Company from October 5, as noted in Figure 16.1. Based on the size of the trend line, I surmised that a break below may lead to a significant drop in share price. I had already noticed significant deterioration in other similar companies such as Monsanto and believed that it may be only a matter of time until this weakness spread to Mosaic. My notes were as follows.
Journal Entry
Mosaic has developed a significant angular ascending trend line from October 5. A move below this trend line may result in a further decline in the stock. I desire to take a reactionary short, once the stock breaches this trend line.
April 9, 2010
- Mosaic has dropped below the angular ascending trend line support.
- Stop above today’s high $58.22, actual stop $58.25. (I rounded up my stop level for no other reason than to simplify the math.)
- Entry at close $56.65 with a $1,000 risk.
- Stop ($58.25) – entry ($56.65) = $1.60.
- Total desired risk ($1,000) / risk of trade ($1.60) = Share count (625).
- Trade taken: Short 625 MOS @ $56.65.
- Stop entered: Stop 625 MOS @ $58.25.
- Profit limit entered for 1/3 shares: Buy 208 MOS @ $55.05 (entry price – risk of trade).
April 16, 2010
- Covered 208 MOS @ $55.05 (initial realized profit $332.80).
- Stop lowered to entry $56.65.
- Profit limit entered: Buy 208 MOS @ $53.45 (entry price – 2x risk of trade).
April 19, 2010
- Covered 208 MOS @ $53.45 (partial realized profit $665.60) (total realized profit $998.40).
- Stop lowered to first profit target $55.05.
Figure 16.1 Mosaic breaking below an ascending angular trend.
Chart courtesy of Worden–www.Worden.com.
This is an example of a trade that worked very well and became quite profitable. Regardless of the outcome, the execution is of utmost importance. If you continuously execute your trading plan, you should see a dramatic difference in your consistency, which should correlate with improved returns. Over time, seek to improve your overall read of the opportunities present and seek to improve your entry strategy as you attempt to maximize your returns while limiting your risk. Incorporate different reads such as trading pattern failure; however, pursue the same execution strategy. As you evolve you will quickly see where your trading needs improvement and where to focus your energy going forward.