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Plan Your Trade, Trade Your Plan!

One of the most interesting and fulfilling experiences I have had in my 30 year career as a professional trader, moneymanager and educator has been my work with the hundreds of professional traders at the Chicago Mercantile Exchange and Chicago Board of Trade trying to make the transition from being floor traders to 'off-floor' or 'screen traders.' For the past 2? years, I've been teaching half-day Market Map Seminars and then acting as mentor to many of these professionals. Some of them have 25 years trading experience and some of them are fairly inexperienced and want to start their career 'off floor'. But all of them want to be consistent winning traders.

Most beginning traders think that they have to find the 'magic' entry method to be a successful trader. When they struggle, they begin hunting for the newest, hottest indicator-the one touted in the advertisements that take that new supercomputer to run, because it's built with 'cutting edge' technology.

Becoming a successful trader depends on a trader finding a tool that helps you spot repeatable patterns. Becoming a successful trader depends on taking the time to master the tool you have chosen to make your own. And most important, becoming a successful trader means you must master yourself. That means you have to look deep within yourself and identify your strengths and weakness. And then put in the work to overcome your weaknesses and play to your strengths. Becoming a successful trader is hard work, but the payoff is well worth the effort.

All traders experience difficulty with self-discipline. A trader can have the best entry tool available and if they can't follow their own rules, they'll likely fail. Successful and profitable trading takes a solid repeatable entry set up, moneymanagement, good risk reward ratios and most of all, these things must be planned in advance and then the plan mustbe executed as the market is moving in real-time.

Inexperienced traders have trouble with discipline because they don't understand just how important it is. The professional traders I work with that are trying to 'relearn' their craft by becoming 'off floor' traders have problems withself discipline because on the floor, they are used to making trading decisions instinctively. But when they sit down infront of the screen to trade, they find it's a different experience and they fall into the same traps that generally trip up inexperienced traders. How can you improve your discipline as a trader?

When I work with traders at the Chicago exchanges, I make them fill out a potential trade entry sheet before they take a trade. The sheet is designed to make each trader think about why they are entering a trade, where in relation to theday's range they are entering a trade, how much are they initially risking on that trade and how much do they expect to make on that trade if it hits their profit target. This forces them to go through basic money management and risk rewardanalysis. If the entry order gets hit, they then have to keep track of how they manage their orders. Again, this reinforces their money management skills. And last, once the trade is closed out, they have to rate the trade and give a brief description of how they feel they executed that particular trade. Here's what one of the potential trade sheets look's like:

How do I get these professional traders into the habit of filling out trade sheets? All traders are the same: They want to talk about trading and they want to talk to their mentor about their trades. Because I have several hundred traders at the two exchanges vying to get in to see me and talk about their trading or ask questions during my 'open office' hours, I have one rule for admittance: A trader must bring in a completed trade sheet and a chart of the trade or I won't talk to them about the trade or their trading. Sound severe? Trading is hard work and only the traders that are willing to put inthe work will survive. I drive this point home day in and day out with this simple technique. Successful traders learn earlyon to have a plan and then to trade their plan. And the easiest way for me to teach them to 'have a plan' is to make them fill out potential trade sheets and keep images of their charts.

I cannot tell how strongly I recommend you try this in your own trading. This is very much like keeping a trading journal-another great tool that helps instill discipline-but by design, it makes you go through the potential trade, step by step.And by design, it makes you check your entry method, your money management, your risk reward, your order management and finally, it makes you review just how you did on each of these steps for any given trade.

If you'd like a copy of the Market Maps Trade Sheet, just drop me an email with the words 'trade sheet' in the subject or body of the email, or you can email me and simply ask for one. Here's the email address you should use:

I'll gladly send you out two versions, a Microsoft's Excel spreadsheet and a Microsoft's Word document. You can use whichever is easier for you!

But more important, plan your trade and trade your plan!



Swing Highs and Swing Lows: Are We There Yet?

Many traders count themselves amongst the legions of “swing traders,” entering long or short positions as price approaches potential swing highs or swing lows. Other traders are intraday scalpers and use swing highs or swing lows as formations to hide stop loss orders above or below, taking advantage of the build up of entry orders from swing traders at these regional extremes. But the question to both groups of traders is always the same: Are we there yet? Have we reached the buying zone or selling zone?

By definition, swing traders are always trying to sell rallies in a down trend and buy dips in an up trend. Then they can try to ride the “swing” or swings higher, running trailing stops that “box” in their profits as price moves in their favor.

But the peril is always the same: Has a recent rally within an established down trend finally reached an area where a top will form and price will then return to the major down trend—OR—Has price violated the down trend and a new up trend had begun? As a swing trader, you always run the risk of being “hit by the train” of a change in trend. Is there a way to better gauge whether price is running out of energy and is about to turn OR is likely to continue, running right through its likely stopping area?

I’ve done a tremendous amount of charting and statistical analysis over the past five years developing tools to keep me from “stepping in front of the train” of newly emerging trends. And one of the most useful ways I have found is to analyze the qualities of the price bars as they approach these likely turning points. The quality I am looking for I have named “Separation” and hopefully these charts and this description will help you successfully identify turning points and keep you from stepping in front of the trains! Let’s look at a chart:

In this example, price has climbed higher and I added in a down sloping pitchfork, or Median Line, to show me the potential path of price IF I have identified a swing high. But note that this upper red line has not been “tested” by price.To relate this term “tested” to trend lines, trend lines are generally drawn by connecting two prior highs or two prior lows.If you choose a prior high and then randomly pick a point in space, rather than draw the trend line by connecting it to another prior high, you get a line in space that has a slope that may or may not have meaning—you won’t know until it is tested. An untested Median Line has a bit more validity because of the mathematical relationship of the three alternating pivots used to draw it, but it becomes much more valid once it has been tested.

To make the analogy easier to understand, let’s turn the down sloping line into a simple trend line. And we’ll state upfront that this trend line is drawn from two prior high pivots. Now we have an area where we think price MAY stop at, but WILL IT stop at this trend line?

Let’s think about what would make it stop at the trend line: Price has topped out twice at this area. This leads traders to feel it’s likely to follow the same pattern. So there may indeed be good orders to sell at or above this trend line, because price has stopped here before. One famous trading motto is: “Beat on a line that is working until it beats you”. If there are a good deal of traders waiting to sell at or above this trend line, price will test it and price will fail to go higher—and probably run a good bit lower in a short period of time as traders try to get short as it becomes obvious that a top is forming.

Now what would make price run higher through this line? If most traders are already short this market, either from the prior test of this trend line or from other areas, they may have a great deal of stops being worked in the market just above this trend line. If this is the case, once price tests and begins to violate this trend line, price will accelerate through this trend line very quickly and move higher.

If price approaches the trend line but does not test or violate it at all, I still won’t know if a top is in, because I won’t know if there are sell orders or stop buy orders above the trend line. Because price hasn’t yet “peeked” beyond the doorway, I don’t what is beyond it.

Here you can see that once price ran up above the trend line formed by prior highs, there were lots of stop loss buyers and these orders pushed prices much higher—and price closed well above the trend line that I originally wanted to get short against. The distance above the trend line that price moved is our first look at “Separation”. In this case, price closed with good separation above the trend line, which shows good buying interest. There is NO sign of weakness on this chart and no reason to attempt to pick a swing top.

In this example, price tested the trend line, ran a bit higher when some buy stops were hit and then suddenly found nothing but eager sellers waiting to get short as the buy stop orders disappeared. Note that price went well above the trend line but closed well below the trend line, which is also great “Separation,” but in this case it is down side separation and is a major sign of weakness.

Having the upper separation, even though the lower separation gives me the sign of weakness I wanted to see before trying to enter a short position, is important because it tells me price gave the buyers all the chance in the world to take control of this market and they failed to take control. And once the sellers took control, they ran price back down throughthe trend line and quite a bit more—Again, a sign a major weakness.

In this case, price barely peeked above the trend line, giving me no up side separation. Although price then traded quite a bit lower, I am not as confident about the test of the trend line, because there may still be nothing but buy stops waiting above the trend line. And as price turned lower, new short positions were probably added. But these new short positions do not have much profit in them and any turn back up to re-test the trend line may run into not only the original stop loss buy orders that have accumulated there, but may also run into additional stop loss orders because of the fresh new short positions from this recent move down.

Here you can see price climbed well above the trend line and did find enough sellers to push price back down to just below the trend line. So there is good up side separation but poor down side separation. This means that even though we found solid sellers once all the buy stops were run above the trend line, we did not find enough aggressive sellers topush price a good amount below the trend line—which would have been a sign of weakness. In this case, I am afraid of the old saying: “What was resistance is now support.” The new short positions established at or above the trend line do not have much profit in them and any move back above the trend line is likely to again provoke a fresh round of stop loss buying, pushing prices to new highs.

Let’s look again at an example with good upper separation and good lower separation. When both are present, we know price gave the buyers every chance to take control of the situation. But once the market ran out of buyers, fresh sellers came into the market and took control, pushing price back down through trend line and forcing it much lower, leaving good down side separation. Having separation above and below the market tells me that the area has been “well scouted” and the close of the bar tells me whether buyers or sellers were in control. In this case, the area was “well scouted” and the sellers were clearly in control when the bar closed. This is a sign of major weakness.

Once we have good upper and lower separation and price closes on an extreme, how can we enter the market? In this case, price closed near its lows and gave me a major sign of weakness after leaving good upper and lower separation. IF price re-approaches the trend line, I will get short as it approaches that area and my stop loss orders will go above the high that marks the upper separation. I expect to find sellers above the trend line because they so convincingly took control the last time price was above the trend line. So I expect the sell orders will act as a buffer, or protection, and I purposely hide my stop loss order above this recently made price formation. These orders should effectively keep mefrom being run over “by the train”.

Now let me simply put the slope back into the trend line. Again, we see great up side separation and great down side separation. And price closed near its lows. The sign of weakness is obvious and if price comes back up to the downsloping line, I would initiate a short position and my stop loss order would go above the top of the recently made high—just above the upper separation. I expect fresh sellers will emerge to help buffer any rise above this trend line,which will help protect my short position.

Other traders often ask me how to identify swing highs or lows “as they occur” and if my analysis is correct, at the end ofthe day, I’ll be able to look back at this peek above the trend line as swing high. And so as it unfolds, I refer to these potential extreme bars as “Pseudo” swing highs or lows. As you get more practice watching price action unfold in “realtime” and learn to think several steps ahead as price tests these areas, you’ll begin to see more “Pseudo Swings” in real-time and that’s when you’ll begin to catch swing highs and swing lows and still do a good job missing being hit by the run away trains!



Risk Reward Ratio:
The Gear That Makes the Profit Engine Run

Who makes more money, day after day: a trader that takes a loss on two out of every three trades he takes or a trader that makes money on eight out of every ten trades he makes? The answer is obvious, right?

Or is it? Before you read any further, let me give a warning: I am about to talk about the mechanics of becoming a profitable trader. And when most traders start to think about what's going on behind the actual trading, their eyes glaze over and they quickly start to lose interest. If you aren't interested in knowing about simple things that can radically improve your chances of being a long term profitable trader, stop reading now. But if you really do want to know more about one of the most important tools in a successful trader's tool box, read on.

Most traders think about their winning trades and their thoughts end there. But in the harsh light of day, a trader's winning trades are far less than half the story. If a trader makes 100 trades and 80 of them are winners but the average winning trade is $100 per contract and the average losing trade is $800 per contract, he or she is in real trouble! Let's do the math: this trader will make $8,000 [80 X $100] on their winning trades. But on the small minority of their winning trades, they'll lose $16,000 [20 X $$800]. And of course, all traders pay commissions on winners and losers. So the truth is even worse: this particular trader would have made winning trades 80 percent of the time and net lost $8,500 forthese 100 trades!

When I teach about risk reward ratios in seminars, some traders initially fight this concept and argue that the high per trade loss of the trader in the example above might have been due to a one time event, an unusual loss caused by an event like the stock market collapse following the 9/11 bombings in the United States. But the sad truth is that if I had the ability to open 1000 monthly trading statements from 1000 traders selected at random by the National Futures Association and show them to you, more than 90 percent of those statements would show losing months. Most people would guess that the losing statements contained mostly losing trades. But if we were able to dig deep into the statistics of the trades, we'd generally find that the most common cause for the losing months was the make up of winning trades as they compared to losing trades: losing traders have poor risk reward ratios and generally don't have a clue that theyare on the road to ruin.

Let's look at an example of a trader that loses on two out every three trades, yet makes money month after month. How is that possible? This second trader makes 100 trades and only 33 of them are winners but the average winning trade is $500 per contract and the average losing trade is $200 per contract. So even though the second trader might have a more difficult emotional ride [because they are only winning 1/3 of the time they take a trade], at the end of the month they'd have money in their pocket! Let's do the math: this trader will lose $13,332 [66.66 X $200] on their losing trades. But on the small minority of their winning trades, they'll win $16,665 [33.33 X $500]. And again, they pay commissions on winners and losers. This particular trader would have made winning trades only 33.33 percent of the time, yet they would have net made $2,833 for these 100 trades!

Here's a table comparing a set of a 100 trades from three traders with three very different risk reward ratios:

The first thing to note is that as a trader, you can have a losing percentage less than 50 percent and make money trading, as long as your risk reward ratio is large enough to overcome the trading style you have embraced: more losers than winners. That simply means your winning trades have to be larger than your losers by a wide enough margin to account for your winning percentage. Many system traders have a win/loss ratio that is less than 50 percent and yet if they have a solid system and follow their system day after day, they end up net winners at the end of the month. It's not always easy to take that next trade when you know you lose 2 out of every 3 times you take a trade, but if the right risk reward ratio has been 'built' into the system or methodology, a disciplined trader will take the next trade and the next trade and the next and at the end of the month, the statement will show that following the plan pays off by delivering a net winning month.

I haven't yet mentioned the most important part of risk reward ratios: they need to be calculated, planned and embraced before any trading begins. As a trader, if you don't have a trading plan, you are trying to steer a ship without a compass in the middle of the dark stormy ocean. And the National Futures Association statistics would say that you are generally about to run your ship into the rocks! Even if you have a solid trade entry methodology, you need to know the maximum amount of money per contract you are going to risk on that trade. And you need to have a realistic profit target for that trade planned out. From these two values, you can calculate your risk reward ratio on that trade-before you take the trade, of course. And going forward, you can examine the historic results of your trade entry methodology to get a feel for the winning percentage of trades you are likely to generate. Then by combining a realistic winning percentage with a realistic risk reward ratio, you'll immediately be able to project your expected trading results forward. And like using a compass and map to steer a ship, you'll immediately see if you are headed for the rocks or headed safely towards the harbor.

Remember: before you trade, you need to find a methodology that fits your personality-one that you are comfortable with and have researched, paper traded and decided is the methodology you will use to manage your capital. Then you need to have a trade plan. And one of the key components in this trade plan has to be what risk reward ratio you realistically expect to see when you analyze your trades at the end of each month.

The third trader in the table gives you a glimpse of what my own personal trading plan statistics look like on each 100 trades. My long term minimum acceptable risk reward ratio is 2:1. That means that for every dollar I risk, I expect to make at least two dollars. When I look at a potential trade, I don't even consider taking trades that have a realistic risk reward ratio of less than 2:1. In actual trading, my long term risk reward ratio hovers around three and a half dollars made for every dollar risked-but I use a 2:1 risk reward ratio in my trading plan because I always want to use aconservative measure. My win to loss percentage over my 30 plus years of trading is right around 65 percent winning trades to 35 percent losing trades. I am much more emotionally comfortable trading a style that has more winners than losers. You can see that a trading plan built upon these parameters will be extremely profitable. But to get to these results on a regular basis, you have to start out with a sound trading plan and methodology. Trading is so much more than looking at a chart and deciding 'now' is a good time to buy or sell. Don't put yourself in that position. Do your homework and learn about the tools used behind the scenes that can help make you a long term profitable trader.